Capital Budgeting

Long-term investment decisions - the key to long run profitability and success!

While long-term investment decisions may take less of a typical finance managers time than working capital decisions, capital budgeting decisions affect the business for years to come, and are critical to strategic success and survival.

The main idea:

We want to invest in projects where the value of the future returns is greater than the cost. If value is greater than cost, the extra value enhances stockholders wealth.

The greatest difficulty:

While the initial cost of a project may be known, future cash flow benefits from the project are usually uncertain. Any of several mathematical models can be used to compute the advantage in accepting an investment when the cash flows are certain, but none can guarantee success if the cash flows are uncertain. There are ways to understand the implications of risk, but no ways to eliminate uncertainty.

Lets consider some ways to identify a good investment project:

Decision method number 1:
The Net Present Value method (NPV): NPV = PV of Future Benefits - PV of the Cost Logically, if NPV > 0, benefits exceed costs, and the project should be accepted. If NPV < 0, the project should be rejected.

An example:
Assume a manufacturer could invest $250,000 in new machines to speed up its production lines. The new machines would allow sales to increase by $75,000 per year over their useful life of 8 years. The annual cash operating cost of the new machines is $10,000. The annual depreciation expense would be $31,250 (using straight-line depreciation method). The corporate tax rate is 30%.

In the rest of this slide presentation, dont worry too much about
The exact way to estimate the annual cash flows resulting from the project. How to mathematically calculate the IRR.

These things are explained in the next presentation (capbud2), and in the text.

Assume that the cost of capital to finance the investment is 12%. What is the projects NPV?
Annual cash flow benefits = ($75,000 $10,000 - $31,250)x(1 - .3) + $31,250 = $54,875. The present value of these cash flows over eight years = PV of an annuity = $272,600. NPV = $272,600 - $250,000 = $22,600.

If the projected cash flows are accurate, then the acceptance of this project should increase stockholders wealth by $22,600. The NPV represents the benefit to stockholders from accepting the project. In this case, the positive NPV indicates an attractive investment.

Method number 2 for making capital budgeting decisions:

The IRR method IRR = the rate of return earned on the project Logically, if IRR > the cost of capital to finance the project, the project should be accepted. If IRR < cost of capital, the project should be rejected

Returning to the example project:

Notice that if the NPV of the project had been 0 when the cost of capital was 12%, we would have known that the project earned a rate of return of 12%. [Since the ROR = cost of capital, the project is neither attractive nor unattractive to accept.] This understanding shows that the IRR can be calculated by finding the interest rate that would make the NPV of the project = 0.

For the example project, the NPV is 0 when the interest rate is 14.5%. Thus, the project has an IRR = 14.5%.
If, as before, the cost of capital is 12%, the project is attractive because it has an IRR > cost of capital. Note that stockholders wealth is increased by the project. It earns a rate of return (IRR) greater than the cost of financing it. The excess return flows to the stockholders.

It should be noted that for any individual investment project, the NPV will be > 0 only when IRR > cost of capital.
Thus, for any individual project, NPV and IRR methods will give the same accept/reject decision.

One other method can be used to get the same decision:

Method number 3: The Profitability index (PI) PI = (PV of Future Benefits)/(PV of the Cost)

Comparing the PI formula to the NPV formula, we note that PI > 1 when NPV > 0.
NPV = PV of Future Benefits - PV of the Cost PI = (PV of Future Benefits)/(PV of the Cost) Logically, we should accept projects when PI >1 and reject projects when PI < 1.

Calculating PI for the example project:

PI = (PV of Future Benefits)/(PV of the Cost) PI = $272,600/$250,000 PI = 1.09 Since PI >1.00, the project should be accepted.

One other evaluation technique before we leave this topic:

The payback period Payback period is recognized today to be an inappropriate way to make capital budgeting decisions. However, it is still a number that is useful to some decision makers in combination with one of the three other methods already explained.

The payback period:

Payback period = the number of years it will take to return the original investment Calculation of payback period ignores the time value of money. (This is a critical flaw!)

For the example project:

Annual cash flow benefits were already calculated to be $54,875.
It will take 250,000/54,875 years to return the original investment cost. Thus, the payback period = 4.56 years.

Besides ignoring the timing of the cash flows, the payback period has two other flaws:
The payback period does not indicate whether the project should be accepted or rejected. For example, we dont know whether 4.56 years is a good payback period, or not. Cash flows that occur after the end of the payback time are ignored in the calculation of payback period. Yet, these latter cash flows may be significant in making the decision.

In summary:
Either the NPV, IRR, or PI methods can be used to make good decisions about capital budgeting investments. Uncertainty about the future cash flow estimates is problematic. Payback period is often calculated for investment projects, but it should not be used by itself to make accept/reject decisions.