In this topic, you will learn how companies make capital budgeting decisions. Capital budgeting decisions are the most important investment decisions made by companies management teams. Capital investments are important because they involve substantial cash outlays and, once made, are not easily reversed. In this topic, you will learn different types of capital budgeting techniques and which one is the best technique.

Concepts covered in this topic are as follows:

Concept 1: What is capital budgeting?

Concept 2: Types of projects.

Concept 3: Evaluate projects using non-discounted cash flow methods. Discuss the advantages and disadvantages of non-discounted cash flow methods.

Concept 4: Evaluate projects using discounted cash flow methods. Discuss the advantages and disadvantages of discounted cash flow methods.

Concept 5: NPV method is preferred to all other methods

Concept 1: What is capital budgeting?

Capital budgeting is a process a business undertakes to evaluate potential major projects or investments. Capital budgeting techniques help management to systematically analyse potential business opportunities to decide which are worth undertaking.

The goal of these decisions is to select capital projects that will increase the value of the company. An investment in a project will create value if it generates more cash inflows than its cost. It is also important to note that the projects that a firm invests in will determine its business risk. Example – Hayat hotels deciding to invest in a casino could alter their riskiness by entering a new line of business (Casinos).

Concept 2: Types of projects

Capital budgeting projects can be broadly classified into three types:

• Independent projects
• Mutually exclusive projects
• Contingent projects

Concept 3: Evaluate projects using non-discounted cash flow methods. Discuss the advantages and disadvantages of non-discounted cash flow methods.

Methods of Project Evaluation using non-discounted cash-flow methods are:

1. Payback period
2. Accounting rate of return

These methods do not involve discounting future net cash-flows back to time 0.

Non-Discounted Cash-Flow Methods – Payback Period Method

The payback period is the amount of time required for an investment to generate net cash flows to cover the initial cost of the investment. An investment is accepted if its payback period is below some pre-specified threshold (e.g. 5 years). This technique can serve as a risk indicator since the more quickly you recover the cash, the less risky the project is.

To calculate the payback period:

Identify the number of years that will pass before the year in which the cost will be fully recovered, and then add to this the relevant fraction of the year in which the total cost will be recovered.

Example of Payback Period Cash Flows and Calculations

A project needs an initial investment (cash outflow) of $70,000 (at time 0).

Net cash inflows expected are: Yr 1 $30,000; Yr 2 $30,000; Yr 3 $20,000, & Yr 4 $15,000. What is the payback period of this project?

The table above shows that the payback period should be somewhere within Year 3 where Cumulative Cash flow becomes 0.

Payback period is: 2 + (10,000/20,000)= 2.5 years

No economic rationale links the payback method to shareholder wealth maximization. Below example illustrates this point.

Payback Periods:

Project AAA is 2 years

Project BBB is 3 years

Project CCC is 3 years

If you assume that these projects are mutually exclusive, you can only invest in one of the projects.

Payback Period Method Decision:

Choose the project that pays itself off most quickly – Project AAA.

This decision is not correct because Project CCC involves much higher net cash-inflows and will most likely increase the firm’s market value by the most.

Advantages of Payback Period Method

• Simplicity of the measure: The payback period calculation is straightforward to understand, which makes it accessible to a wide range of stakeholders, including business owners, investors, and managers.
• Measures liquidity: The payback period measures the liquidity of an investment, which is the ability of an investment to generate cash flows and recover its initial cost quickly. This is important for businesses that need to maintain a certain level of liquidity to operate effectively.
• Considers risk: The payback period takes into account the time it takes to recover the initial investment, which is a critical factor in assessing the investment’s risk. A shorter payback period indicates a lower risk investment as the initial cost is recovered more quickly.
• Can be a benchmark: The payback period can be used as a benchmark to compare different investment options. This can help businesses evaluate which investment will provide the most significant return on their investment in the shortest amount of time.
• Encourages capital conservation: The payback period encourages capital conservation as it measures the time it takes to recover the initial investment. This can help businesses evaluate whether an investment is worth the cost and avoid investing in projects that may take too long to recover the initial cost.

Disadvantages of the Payback Period Method

• Ignores time value of money: The payback period calculation does not consider the time value of money, which means that it does not take into account the fact that money received in the future is worth less than money received today. This can lead to an inaccurate assessment of the investment’s profitability.
• Ignores cash flows beyond the payback period: The payback period only measures the time it takes for an investment to recover its initial cost. It does not consider the cash flows generated by the investment beyond the payback period. This can lead to a limited view of an investment’s profitability potential.
• Ignores risk: The payback period does not take into account the risk associated with an investment, such as the volatility of cash flows or the uncertainty of future market conditions. This can lead to an inaccurate assessment of the investment’s overall potential.
• Subjective determination of payback period: The determination of the payback period involves subjective decisions about the appropriate length of time to recover the initial investment. Different people may arrive at different payback periods for the same investment, which can lead to inconsistency in decision-making.

Non-Discounted Cash-Flow Methods – Accounting Rate of Return (ARR)

It is a measure of an investment’s profitability, measured as:

A project is accepted if its ARR > the target rate of return. The target rate is determined by management.

Example of calculation of ARR:

Suppose the initial cost of investment (cash outflow at time 0) = $240

What is the ARR based on the average investment measured as the capital invested at the beginning and the end of the project’s life?

Accounting Rate of Return

Average net profit = [latex]\frac{\sum{Net\ Profit}}{n}=\ \frac{105+30+0}{3}=45[/latex]

Average Book Value = [latex]\frac{Intial\ investment+final\ book\ value}{2}=\frac{240+0}{2}=120[/latex]

Accounting Rate of Return

ARR = [latex]\frac{Average\ Net\ Profit}{Average\ Book\ Value}=\frac{45}{120}=0.375=37.5%[/latex]

If, for example, the management’s target rate of return is 20%, then because this project has an ARR of 37.5% (which is > 20%) you would proceed with the project. However, if, for example, the target rate of return is 40%, then because this project has an ARR of 37.5% (which is < 40%) you would reject the project.

Advantages of ARR

• Simple measure: The ARR calculation is straightforward to understand, which makes it accessible to a wide range of stakeholders, including business owners, investors, and managers.
• Uses accounting data: The ARR relies on accounting data, such as net income and book value, which are readily available in a company’s financial statements. This makes it easy to calculate and compare the returns of different investments.
• Focuses on profitability: The ARR measures the profitability of an investment, which is a critical factor in decision-making. It helps businesses assess whether an investment will likely generate a sufficient return to justify the investment.
• Long-term view: The ARR considers the expected returns over the investment’s entire life, which is a more comprehensive approach than other metrics, such as payback period or net present value, which only consider the initial investment and cash flows.
• Considers non-cash items: The ARR takes into account non-cash items, such as depreciation and amortization, which can have a significant impact on a company’s profitability.

Disadvantages of ARR

• Ignores the time value of money: ARR does not take into account the time value of money, which means that it does not consider the fact that money received in the future is worth less than money received today due to inflation and other factors. This can lead to an inaccurate assessment of the investment’s profitability.
• Relies on accounting data: While using accounting data is an advantage, it can also be a disadvantage. The ARR calculation is based on historical accounting data, which may not reflect the current or future market conditions. Therefore, it may not be a reliable indicator of an investment’s profitability.
• Ignores cash flows: The ARR does not consider the timing and amount of cash flows associated with an investment. This can lead to an inaccurate assessment of the investment’s profitability, particularly in cases where cash flows are uneven or vary significantly over time.
• Ignores the risk: The ARR does not consider the risk associated with an investment. An investment with a higher ARR may not necessarily be a better investment if it has a higher level of risk than an investment with a lower ARR.
• Subjectivity: The ARR calculation involves making assumptions and estimates, such as the useful life of an asset or the salvage value, which can be subjective and may vary from person to person. This can lead to different people arriving at different ARR values for the same investment.

Concept 4: Evaluate projects using discounted cash flow methods. Discuss advantages and disadvantages of discounted cash flows methods

Methods of Project Evaluation using discounted cash-flow methods are:

• Net present value (NPV)
• Internal rate of return (IRR)

These methods do involve the discounting of future net cash-flows back to time 0.

Discounted Cash-Flow Methods – Net Present Value

NPV method estimates the amount by which the benefits (cash inflows) from a project exceed the cost of the project in present value (dollar) terms. NPV is a capital budgeting technique that is consistent with the goal of maximizing shareholder wealth. NPV provides a $ value of how much cash is flowing out or in to the firm.

NPV= PV of cash inflows less PV of cash outflows

Net Present Value Analysis

Net Present Value (NPV) analysis is used in finance to evaluate investment projects by comparing the present value of expected cash inflows to the present value of expected cash outflows, considering the time value of money. The basic principle underlying NPV analysis is that a dollar received in the future is worth less than a dollar received today because of the opportunity cost of not investing that money today.

In simple terms, NPV analysis involves taking the expected cash inflows and outflows associated with an investment project and discounting them back to their present value using a discount rate, which reflects the cost of capital or minimum required return. The resulting net present value represents the difference between the present value of the expected cash inflows and the present value of the expected cash outflows.

If the NPV is positive, it suggests that the investment project will generate more cash than the initial investment, and therefore, it may be worth pursuing. If the NPV is negative, it suggests that the investment project will not generate enough cash to cover the initial investment and it may not be worth pursuing.

NPV analysis can be a powerful tool for businesses and investors to make informed decisions about capital allocation and risk management. By taking into account the time value of money, expected cash flows, and the cost of capital, NPV analysis helps in making sound investment decisions.

Steps to calculate NPV

1. Identify the investment project: Select the investment project that needs to be evaluated.
2. Estimate the cash flows: Estimate the cash flows that the project will generate over its lifetime, including the initial investment, expected inflows, and expected outflows.
3. Determine the discount rate: Determine the discount rate, which is the rate used to convert future cash flows into present values. The discount rate is usually based on the cost of capital, which is the minimum return required by investors for the investment to be worth pursuing.
4. Calculate the present value of each cash flow: Convert each cash flow to its present value using the discount rate. The formula for calculating the present value is PV = CF / (1+r)^n, where PV is the present value, CF is the cash flow, r is the discount rate, and n is the number of years into the future that the cash flow is expected to occur.
5. Sum up the present values: Sum up the present values of all expected cash flows, including the initial investment, to arrive at the net present value of the investment.
6. Compare the NPV to the initial investment: If the NPV is positive, it indicates that the investment is expected to generate more cash flows than the initial investment, and it may be worth pursuing. If the NPV is negative, it indicates that the investment is not expected to generate enough cash flows to cover the initial investment, and it may not be worth pursuing.

NPV=PV of expected cash inflows less PV of expected cash outflows.

Standard NPV formula is:

Then make a decision. Accept project if NPV is positive; reject project if NPV is Negative.

NPV Example 1

Project AAA will initially cost $300,000 and has a lifespan of five years. Sales from the project will be $300,000 per year and cost of sales and other costs (excluding depreciation) will amount to $220,000 per year. The machinery purchased for the project can be sold at the end of the 5^th year for $30,000.

Assuming that the cost of capital of the firm is 15%, compute the NPV of the project.

NPV Example 1: Solution

Calculate Present Value of Cashflow and sum them up

NPV= -300+801.15+801.152+801.153+801,154+110(1.15)5

NPV = -300 + 69.57 + 60.49 + 52.60 + 45.74 + 54.69

NPV = -$16.91 = -$16,910

Make Accept/Reject Decision Based On NPV

Negative NPV – Do not accept the project

Advantages of NPV

• Time value of money: NPV analysis accounts for the time value of money, recognising that a dollar today is worth more than a dollar in the future due to inflation and the potential for earning a return on that dollar if invested today.
• A precise measure of profitability: NPV analysis provides a clear measure of the profitability of an investment project, by calculating the expected return in terms of present value cash inflows compared to the present value cash outflows.
• Considers all cash flows: NPV analysis considers all cash inflows and outflows over the life of the investment project, including initial investments, operating costs, and expected revenue streams. This helps to provide a comprehensive view of the financial performance of the investment project.
• Takes into the cost of capital: NPV analysis incorporates the cost of capital or minimum required return, which helps businesses and investors to evaluate the investment project’s potential return in comparison to the cost of obtaining funds to finance the project.
• Allows for scenario analysis: NPV analysis allows for scenario analysis, which can help investors and businesses to evaluate the potential impact of different scenarios on the investment project’s financial performance. You will learn this in Topic 7.

Disadvantages of NPV

• Requires accurate cash flow forecasts: NPV analysis requires accurate cash flow forecasts for the life of the investment project. However, in practice, it can be challenging to predict future cash flows with certainty, which can affect the accuracy of the NPV calculation.
• Relies on subjective assumptions: NPV analysis relies on subjective assumptions, such as the discount rate used to calculate the present value of future cash flows. These assumptions can vary depending on the individual or organization making the analysis, which can lead to inconsistencies in decision-making.
• Ignores non-monetary factors: NPV analysis only considers monetary factors and ignores non-monetary factors that may affect the investment project’s success, such as regulatory changes, changes in market conditions, or other external factors.
• Doesn’t account for project size: NPV analysis doesn’t take into account the size of the investment project, and it may be more appropriate to use other financial evaluation methods for smaller projects.
• May not consider risks: NPV analysis may not account for all the risks associated with the investment project. For example, it may not consider the potential impact of project delays, cost overruns, or changes in market conditions, which could affect the project’s financial performance.

Discounted Cash-Flow Methods – Internal Rate of Return (IRR)

IRR and NPV techniques are similar in that both depend on discounting cash flows from a project. IRR method is an important and legitimate alternative to the NPV method. When you use the IRR approach, you are looking for the rate of return (rather than a $ amount) associated with a project so that you can determine whether this rate is higher or lower than the company’s cost of capital (i.e., you compare IRR with the cost of capital)

Internal Rate of Return (IRR)

IRR is the discount rate/interest rate/required rate of return that makes the present value of the project’s future net cash-inflows equal to the cost of the project. IRR is the actual rate of return for the project. A project is accepted if its IRR is > the required rate of return (R). You can calculate IRR using Excel’s IRR function.

Calculation of Internal Rate of Return

By setting the NPV formula to zero and treating the rate of return as the unknown, the IRR is given by:

Calculation of Internal Rate of Return

Example

Find the IRR for the following project:

Choose a discount rate and substitute it into the NPV equation.

If the NPV is negative (positive) the discount rate guessed is too high (low).

By narrowing down the difference between the two rates, we can approach the IRR. In this case the IRR is approximately 73.08%.

IRR= 0.7308: Plug this rate as irr in the equation below and you will get 0:

Calculation of Internal Rate of Return:

You substitute different discount rates and calculate the NPV. Note that as discount rate increases, NPV decreases. 73% is the discount rate that gives an NPV closest to 0. The higher the IRR the better it is for capital budgeting decision.

IRR – Interpretation Example

Project A has an IRR of 15%. The current discount rate (cost of capital) is 10%. Should the project be accepted based on IRR?

Since IRR(15%) > discount rate (10%), you can accept.

Concept 5: NPV method is preferred to all other methods

When IRR & NPV Methods Agree:

The two methods will always agree as to which project is to be selected when:

• the projects are independent, &
• the projects’ cash flows are conventional (i.e. after the initial (Year 0) investment is made (cash outflow), all future net cash flows are positive.

When IRR & NPV Methods Disagree:

The IRR and NPV methods can produce different accept/reject decisions if:

• a project has unconventional cash flows, or
• two or more projects are mutually exclusive.

IRR and Unconventional Cash Flows

Unconventional cash flows could follow several different patterns. They are:

• A negative initial cash flow is followed by positive future net cash flows and then a final negative cash flow.
• Future net cash flows from a project could be both positive and negative.
• In these circumstances, IRR technique can provide more than one solution, making result unreliable.
• IRR method should not be used in deciding about accepting or rejecting a project when unconventional cash flows are associated with the project.

IRR and Mutually Exclusive Projects
It is possible that NPVs of the two projects will equal each other at a certain discount rate. The point at which the NPVs intersect is called the crossover point. Depending upon whether the required rate of return (discount rate) is above or below this crossover point, the ranking of the projects will be different.

IRR and Reinvestment Rate Assumption
Another major weakness of IRR method compared to NPV method is the reinvestment rate assumption:

• IRR method assumes cash flows from project are reinvested at IRR, while NPV method assumes cash flows are reinvested at company’s cost of capital
• This assumption in IRR method leads to some projects being accepted when they should not be.

IRR v. NPV: Final Comment

While IRR method has intuitive appeal to managers because output is expressed as a rate of return (e.g., 8%), the technique has some critical problems. On the other hand, decisions made based on a project’s NPV are consistent with goal of shareholder wealth maximisation. NPV method shows $ amount by which project is expected to increase value of company. When NPV & IRR are in conflict – always go with NPV. For these reasons mentioned above NPV method should be used to make capital budgeting decisions.

References:

• Peirson, G., Brown, R., Easton, S. A., Howard, P., & Pinder, S. (2015). Business finance (Twelfth edition). McGraw-Hill Education.
• Ross, S. A., Trayler, R., Hambusch, G., Koh, C., Glover, K., Westerfield, R., & Jordan, B. (2021). Fundamentals of corporate finance (Eighth edition.). McGraw-Hill Education (Australia) Pty Limited.
• Parrino, R., Au Yong, H. H., Dempsey, M. J., Ekanayake, S., Kidwell, D. S., Kofoed, J., Morkel-Kingsbury, N., & Murray, J. (2014). Fundamentals of corporate finance (Second edition.). John Wiley and Sons Australia, Ltd.