CAPITAL BUDGETING

INTRODUCTION

Capital budgeting (or investment appraisal) is the planning process

used to determine whether an organisation's long term investments
such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing. It is
budget for major capital, or investment, expenditures.

Capital budgeting is a process used to determine whether a firm’s

proposed investments or projects are worth undertaking or not. The
process of allocating budget for fixed investment opportunities is
crucial because they are generally long lived and not easily reversed
once they are made. So we can say that this is a strategic asset
allocation process and management needs to use capital budgeting
techniques to determine which project will yield more return over a
period of time.

The question arises why capital budgeting decisions are critical?

The foremost importance is that the capital is a limited resource which
is true of any form of capital, whether it is raised through debt or
equity. The firms always face the constraint of capital rationing. This
may result in the selection of less profitable investment proposals if
the budget allocation and utilization is the primary consideration. So
the management should make a careful decision whether a particular
project is economically acceptable and within the specified limits of the
investments to be made during a specified period of time. In the case
of more than one project, management must identify the combination
of investment projects that will contribute to the value of the firm and
profitability. This, in essence, is the basis of capital budgeting.
TECHNIQUES OF CAPITAL BUDGETING

Many formal methods are used in capital budgeting, including the

techniques such as

• Accounting rate of return

• Net present value
• Profitability index
• Internal rate of return
• Modified internal rate of return
• Equivalent annuity

These methods use the incremental cash flows from each potential
investment, or project. Techniques based on accounting earnings and
accounting rules are sometimes used - though economists consider
this to be improper - such as the accounting rate of return, and "return
on investment." Simplified and hybrid methods are used as well, such
as payback period and discounted payback period.
NET PRESENT VALUE

Each potential project's value should be estimated using a discounted

cash flow (DCF) valuation, to find its net present value (NPV). (First
applied to Corporate Finance by Joel Dean in 1951) This valuation
requires estimating the size and timing of all the incremental cash
flows from the project. These future cash flows are then discounted to
determine their present value. These present values are then summed,
to get the NPV. See also Time value of money. The NPV decision rule is
to accept all positive NPV projects in an unconstrained environment, or
if projects are mutually exclusive, accept the one with the highest NPV
(GE).

The NPV is greatly affected by the discount rate, so selecting the

proper rate - sometimes called the hurdle rate - is critical to making
the right decision. The hurdle rate is the minimum acceptable return
on an investment. It should reflect the riskiness of the investment,
typically measured by the volatility of cash flows, and must take into
account the financing mix. Managers may use models such as the
CAPM or the APT to estimate a discount rate appropriate for each
particular project, and use the weighted average cost of capital
(WACC) to reflect the financing mix selected. A common practice in
choosing a discount rate for a project is to apply a WACC that applies
to the entire firm, but a higher discount rate may be more appropriate
when a project's risk is higher than the risk of the firm as a whole.
Net Present Value measures the difference between present value of
future cash inflows generated by a project and cash outflows during a
specific period of time. With a help of net present value we can figure
out an investment that is expected to generate positive cash flows.

In order to calculate net present value (NPV), we first estimate the

expected future cash flows from a project under consideration. The
next step is to calculate the present value of these cash flows by
applying the discounted cash flow (DCF) valuation procedures. Once
we have the estimated figures then we will estimate NPV as the
difference between present value of cash inflows and the cost of
investment.

NPV Formula:

NPV=Present Value of Future Cash Inflows – Cash Outflows

(Investment Cost)

In addition to this formula, there are various tools available to

calculate the net present value e.g. by using tables and spreadsheets
such as Microsoft Excel.

Decision Rule:

A prospective investment should be accepted if its Net Present Value is

positive and rejected if it is negative.
INTERNAL RATE OF RETURN

The internal rate of return (IRR) is defined as the discount rate that
gives a net present value (NPV) of zero. It is a commonly used
measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for
(non-mutually exclusive) projects in an unconstrained environment, in
the usual cases where a negative cash flow occurs at the start of the
project, followed by all positive cash flows. In most realistic cases, all
independent projects that have an IRR higher than the hurdle rate
should be accepted. Nevertheless, for mutually exclusive projects, the
decision rule of taking the project with the highest IRR - which is often
used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is
no unique IRR. The IRR exists and is unique if one or more years of
net investment (negative cash flow) are followed by years of net
revenues. But if the signs of the cash flows change more than once,
there may be several IRRs. The IRR equation generally cannot be
solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly

misunderstood to convey the actual annual profitability of an
investment. However, this is not the case because intermediate cash
flows are almost never reinvested at the project's IRR; and, therefore,
the actual rate of return is almost certainly going to be lower.
Accordingly, a measure called Modified Internal Rate of Return (MIRR)
is often used.
Internal Rate of Return is another important technique used in Capital
Budgeting Analysis to access the viability of an investment proposal.
This is considered to be most important alternative to Net Present
Value (NPV). IRR is “The Discount rate at which the costs of
investment equal to the benefits of the investment. Or in other words
IRR is the Required Rate that equates the NPV of an investment zero.

NPV and IRR methods will always result identical accept/reject

decisions for independent projects. The reason is that whenever NPV is
positive , IRR must exceed Cost of Capital. However this is not true in
case of mutually exclusive projects.

The problem with IRR come about when Cash Flows are non-
conventional or when we are looking for two projects which are
mutually exclusive. Under such circumstances IRR can be misleading.

Suppose we have to evaluate two mutually exclusive projects. One of

the project requires a higher initial investment than the second
project; the first project may have a lower IRR value, but a higher NPV
and should thus be accepted over the second project (assuming no
capital rationing constraint).

Decision Rule of Internal Rate of Return:

If Internal Rate of Return exceeds the required rate of Return, the

investment should be accepted or should be rejected otherwise.
EQUIVALENT ANNUITY METHOD

The equivalent annuity method expresses the NPV as an annualized

cash flow by dividing it by the present value of the annuity factor. It is
often used when assessing only the costs of specific projects that have
the same cash inflows. In this form it is known as the equivalent
annual cost (EAC) method and is the cost per year of owning and
operating an asset over its entire lifespan.

It is often used when comparing investment projects of unequal life

spans.

For example if project A has an expected lifetime of 7 years, and

project B has an expected lifetime of 11 years it would be improper to
simply compare the net present values (NPVs) of the two projects,
unless the projects could not be repeated.

The use of the EAC method implies that the project will be replaced by
an identical project.

Alternatively the chain method can be used with the NPV method
under the assumption that the projects will be replaced with the same
cash flows each time. To compare projects of unequal length, say 3
years and 4 years, the projects are chained together, i.e. four
repetitions of the 3 year project are compare to three repetitions of
the 4 year project. The chain method and the EAC method give
mathematically equivalent answers.

The assumption of the same cash flows for each link in the chain is
essentially an assumption of zero inflation, so a real interest rate
rather than a nominal interest rate is commonly used in the
calculations.

REAL OPTIONS

Real options analysis has become important since the 1970s as option
pricing models have gotten more sophisticated. The discounted cash
flow methods essentially value projects as if they were risky bonds,
with the promised cash flows known. But managers will have many
choices of how to increase future cash inflows, or to decrease future
cash outflows. In other words, managers get to manage the projects -
not simply accept or reject them. Real options analysis try to value the
choices - the option value - that the managers will have in the future
and adds these values to the NPV.

RANKED PROJECTS

The real value of capital budgeting is to rank projects. Most

organizations have many projects that could potentially be financially
rewarding. Once it has been determined that a particular project has
exceeded its hurdle, then it should be ranked against peer projects
(e.g. - highest Profitability index to lowest Profitability index). The
highest ranking projects should be implemented until the budgeted
capital has been expended.
Funding Sources

When a corporation determines its capital budget, it must acquire said

funds. Three methods are generally available to publicly traded
corporations: corporate bonds, preferred stock, and common stock.
The ideal mix of those funding sources is determined by the financial
managers of the firm and is related to the amount of financial risk that
corporation is willing to undertake. Corporate bonds entail the lowest
financial risk and therefore generally have the lowest interest rate.
Preferred stock have no financial risk but dividends, including all in
arrears, must be paid to the preferred stockholders before any cash
disbursements can be made to common stockholders; they generally
have interest rates higher than those of corporate bonds. Finally,
common stocks entail no financial risk but are the most expensive way
to finance capital projects.
Profitability Index- Capital Budgeting Techniques

Profitability Index

Profitability index (PI) is the ratio of investment to payoff of a

suggested project. It is a useful capital budgeting technique for
grading projects because it measures the value created by per unit of
investment made by the investor.

This technique is also known as profit investment ratio (PIR), benefit-

cost ratio and value investment ratio (VIR).

The ratio is calculated as follows:

Profitability Index = Present Value of Future Cash Flows /

Initial Investment
If project has positive NPV, then the PV of future cash flows must be
higher than the initial investment. Thus the Profitability Index for a
project with positive NPV is greater than 1 and less than 1 for a project
with negative NPV. This technique may be useful when available
capital is limited and we can allocate funds to projects with the highest
PIs.

Decision Rule:

Rules for the selection or rejection of a proposed project:

If Profit Index is greater than 1, then project should be accepted.

If Profit Index is less than 1, then reject the project.

Present Value of Multiple Cash Flows

We come across many cases where we have to determine the present

value of series of multiple cash flows. There are two ways we can
calculate present value of multiple cash flows. Either we discount back
individual cash flow at a time, or we can just calculate the present
values individually and add them up.

Example:

Suppose if we want $10,000 in one year and $15,000 more in two

years. If we can earn 8% on this money, how much we need to invest
today to exactly earn this much in the future? In other words, what is
the present value of two cash flows at 8%.

Present value of $15,000 in 2 years at 8 percent is:

$15000/1.082 =$12860.082

Present value of $100 in 1 years at 8% is:

$10,000/1.08 =$9259.259

The total present value is :

$12860.082+$9259.259=$22119.341

Discounted Payback Period – Capital Budgeting Techniques

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Discounted Payback Period

One of the limitations in using payback period is that it does not take
into account the time value of money. Thus, future cash inflows are
not discounted or adjusted for debt/equity used to undertake the
project , inflation, etc. However, the discounted payback period solves
this problem. It considers the time value of money, it shows the
breakeven after covering such costs. This technique is somewhat
similar to payback period except that the expected future cash flows
are discounted for computing payback period.
Discounted payback period is how long an investment’s cash flows,
discounted at project’s cost of capital, will take to cover the initial cost
of the project. In this approach, the PV of future cash inflows are
cumulated up to time they cover the initial cost of the project.
Discounted payback period is generally higher than payback period
because it is money you will get in the future and will be less valuable
than money today.

Payback Period

Payback period is the first formal and basic capital budgeting

technique used to assess the viability of the project. It is defined as
the time period required for the investment’s returns to cover its cost.
Payback period is easy to apply and easy to understand technique;
therefore, widely used by investors.

For example, an investment of $5000 which returns $1000 per year

will have a five year payback period. Shorter payback periods are
more desirable for the investors than longer payback periods.

It is considered as a method of analysis with serious limitations and

qualifications for its use. Because it does not properly account for the
time value of money, risk and other important considerations such as
opportunity cost.
Capital Budgeting Process

Evaluation of Capital budgeting project involves six steps:

• First, the cost of that particular project must be known.

• Second, estimates the expected cash out flows from the project,
including residual value of the asset at the end of its useful life.
• Third, riskiness of the cash flows must be estimated. This
requires information about the probability distribution of the
cash outflows.
• Based on project’s riskiness, Management find outs the cost of
capital at which the cash out flows should be discounted.
• Next determine the present value of expected cash flows.
 • Finally, compare the present value of expected cash flows with
the required outlay. If the present value of the cash flows is
greater than the cost, the project should be taken. Otherwise, it
should be rejected.

OR

• If the expected rate of return on the project exceeds its cost of

capital, that project is worth taking.

Firm’s stock price directly depends how effective are the firm’s capital
budgeting procedures. If the firm finds or creates an investment
opportunity with a present value higher than its cost of capital, this
would effect firms value positively.

Importance of Capital Budgeting Decisions

Capital Budgeting and Financial Management

Businesses look for opportunities that increase their share holders’

value. In capital budgeting, the managers try to figure out investment
opportunities that are worth more to the business than they cost to
acquire. Ideally, firms should peruse all such projects that have good
potential to increase the business worth. Since the available amount of
capital at any given time is limited; therefore, it restricts the
management to pick out only certain projects by using capital
budgeting techniques in order to determine which project has potential
to yield the most return over an applicable period of time.

Capital budgeting is the process which enables the management to

decide which, when and where to make long-term investments. With
the help of Capital Budgeting Techniques, management decide
whether to accept or reject a particular project by making analysis of
the cash flows generated by the project over a period of time and its
cost. Management decides in favor of project if the value of cash flows
generated by the project exceeds the cost of undertaking that project.

A Capital Budgeting Decision rules likely to satisfy the following

criteria:

• Must give consideration to all cash flows generated by the

project.
• Must take into account Time Value of Money concept.
• Must always lead to the correct decision when choosing among
mutually exclusive projects.

Regardless of the specific nature of an investment opportunity under

consideration, management must be concerned not only with how
much cash they are expecting to receive, but also when they expect to
receive it and how likely they are to receive it.

Evaluating the size of investment, timing; when to take that

investment, and the risk involve in taking particular investment is the
essence of capital budgeting.