Capital budgeting

Capital budgeting (or investment appraisal) is the planning process used to determine whether
an organization's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects are worth pursuing. It is budget Ior
major capital, or investment, expenditures.
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Many Iormal methods are used in capital budgeting, including the techniques such as
O ccounting rate oI return
O et present value
O !roIitability index
O Internal rate oI return
O ModiIied internal rate oI return
O quivalent annuity
These methods use the incremental cash Ilows Irom each potential investment, or profect.
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." SimpliIied and hybrid methods are used as well, such as payback period and
discounted payback period.
Net present value
ach potential project's value should be estimated using a discounted cash Ilow (DCF) valuation,
to Iind its net present value (!'). (First applied to Corporate Finance by Joel Dean in 1951; see
also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating
the size and timing oI all the incremental cash Ilows Irom the project. These Iuture cash Ilows
are then discounted to determine their present value. These present values are then summed, to
get the !'. See also Time value oI money. The !' decision rule is to accept all positive !'
projects in an unconstrained environment, or iI projects are mutually exclusive, accept the one
with the highest !'(G).
The !' is greatly aIIected 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 reIlect the riskiness oI the investment, typically
measured by the volatility oI cash Ilows, and must take into account the Iinancing mix. Managers
may use models such as the C!M or the !T to estimate a discount rate appropriate Ior each
particular project, and use the weighted average cost oI capital (WACC) to reIlect the Iinancing
mix selected. common practice in choosing a discount rate Ior a project is to apply a WCC
that applies to the entire Iirm, but a higher discount rate may be more appropriate when a
project's risk is higher than the risk oI the Iirm as a whole.
nternal rate of return
The internal rate of return (IRR) is deIined as the discount rate that gives a net present value
(!') oI zero. It is a commonly used measure oI investment eIIiciency.
The IRR method will result in the same decision as the !' method Ior (non-mutually
exclusive) projects in an unconstrained environment, in the usual cases where a negative cash
Ilow occurs at the start oI the project, Iollowed by all positive cash Ilows. In most realistic cases,
all independent projects that have an IRR higher than the hurdle rate should be accepted.
evertheless, Ior mutually exclusive projects, the decision rule oI taking the project with the
highest IRR - which is oIten used - may select a project with a lower !'.
In some cases, several zero !' discount rates may exist, so there is no unique IRR. The IRR
exists and is unique iI one or more years oI net investment (negative cash Ilow) are Iollowed by
years oI net revenues. But iI the signs oI the cash Ilows change more than once, there may be
several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.
One shortcoming oI the IRR method is that it is commonly misunderstood to convey the actual
annual proIitability oI an investment. However, this is not the case because intermediate cash
Ilows are almost never reinvested at the project's IRR; and, thereIore, the actual rate oI return is
almost certainly going to be lower. ccordingly, a measure called ModiIied Internal Rate oI
Return (MIRR) is oIten used.
Despite a strong academic preIerence Ior !', surveys indicate that executives preIer IRR over
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, although they should be used in concert. In a budget-constrained environment,
eIIiciency measures should be used to maximize the overall !' oI the Iirm. Some managers
Iind it intuitively more appealing to evaluate investments in terms oI percentage rates oI return
than dollars oI !'.
]uivalent annuity metbod
The equivalent annuity method expresses the !' as an annualized cash Ilow by dividing it by
the present value oI the annuity Iactor. It is oIten used when assessing only the costs oI speciIic
projects that have the same cash inIlows. In this Iorm it is known as the equivalent annual cost
(C) method and is the cost per year oI owning and operating an asset over its entire liIespan.
It is oIten used when comparing investment projects oI unequal liIespans. For example iI project
has an expected liIetime oI 7 years, and project B has an expected liIetime oI 11 years it would
be improper to simply compare the net present values (!'s) oI the two projects, unless the
projects could not be repeated.
The use oI the C method implies that the project will be replaced by an identical project.
lternatively the chain method can be used with the !' method under the assumption that the
projects will be replaced with the same cash Ilows each time. To compare projects oI unequal
length, say 3 years and 4 years, the projects are chained together, i.e. Iour repetitions oI the 3
year project are compare to three repetitions oI the 4 year project. The chain method and the
C method give mathematically equivalent answers.
The assumption oI the same cash Ilows Ior each link in the chain is essentially an assumption oI
zero inIlation, so a real interest rate rather than a nominal interest rate is commonly used in the
calculations.Y
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