Critical Appraisal of Traditional Capital Budgeting Techniques

The role of financial management in any corporation is to increase the firm value to the shareholders within the applicable legal framework. The crux of corporate finance therefore centers round achieving this goal by dealing with strategic financial issues associated therewith. This responsibility includes advising the corporation the ways in which capital can be raised and managed, the kinds and nature of investments the company should make, the quantum of profits to be returned to the shareholders as dividends and on the possibilities of enhancing the firm value through merging with or acquiring another firm (QuickMBA, n.d.).

One of the main function of a corporate financial manager is to allocate the scarce capital resources of the firm among the various available investment options and this process is generally referred to as capital budgeting. There are various techniques used to evaluate a capital investment proposal and the objective of all these techniques is to make a comparison of the costs to be incurred on a project and the likely benefits in financial terms from the project. One over-riding rule of all capital budgeting evaluation techniques is to accept all projects for which the cost is lower than the benefits and reject all projects where the cost is more than the benefits.

Objectives of Capital Budgeting

Capital budgeting is connected with sufficient investments in long-term assets. The assets may be tangible like property, plan, and equipment or intangible like new technology, patents, or trademarks. Irrespective of the nature of the assets, the capital expenditures have two characters; one is that they are meant to be a long-term investment and secondly their benefits or cash flows are expected to be spread over many years.

These characteristic features make the capital expenditure decisions very important for a firm. The capital expenditure decisions since have a considerable impact on the organization’s future cash flows there is a considerable risk associated with the capital expenditures. Moreover, the firm usually commits large amounts of funds in capital expenditure projects. Hence, they are considered very important and if any error is made in the capital budgeting decisions, it will affect the performance of the firm by directly affecting the profitability of the company (CapitalBudgeting, n.d.). The capital budgeting is undertaken by any firm to achieve the following objectives:

  • Taking an investment decision on the particular project that the firm should accept for investing
  • Determination of the total amount of capital expenditure that the company should commit on the project selected and
  • Determination of the ways in which the total amount of capital expenditure decided is to be financed

It is necessary that each of the above decisions should be considered based on the estimated contribution the proposed capital expenditure project towards achieving the organizational objectives (Drury, 2004).

Capital budgeting becomes an important aspect in the finance function of any organization, because of the following reasons.

  • The capital budgeting decisions of a firm defines its strategic directions. The strategies may relate to moving into new products or services and markets. Any of these activities can follow only after the company can make its capital expenditure planning.
  • Secondly, the capital budgeting involves major strategic decisions that may affect the growth of the firm in the long-term. The effect of such capital expenditure decisions are likely to last for a significantly longer period.
  • Thirdly, any poor capital budgeting decisions will have serious financial consequences on the performance of the firm.

In general, the aim of any business company is to increase the shareholder value to maximum. According to the theory of capital budgeting, an organization should be able to maximize the shareholder value at a point where the firm is able make its marginal cost meet its marginal revenue. Therefore, the objective of capital budgeting of any firm would be to maximize the shareholder value by investing into those projects, which aid the process of value maximization. In order to arrive at the specific projects the firm has the option of resorting to several capital budgeting techniques, each of which has its own merits and demerits. This paper makes a critical appraisal of these techniques

Capital Budgeting Techniques

Traditionally, there are six methods, which are used for capital project evaluations. They are Payback period, Discounted payback period, Internal rate of return, Modified internal rate of return, Net present value, Profitability index and Capital Asset Pricing Model (CAPM) Descriptive notes on these methods are appended.

Payback Period

“The Payback Period is perhaps the simplest method of looking at one or more investment projects or ideas. The Payback Period method focuses on recovering the cost of investments. The Payback Period represents the amount of time that it takes for a capital budgeting project to recover its initial cost” (12Manage, n.d.). The payback period is the ratio of the initial fixed investment over the annual cash flows for the recovery period.

If the cash flows are an annuity, the total cost of investment is divided by the annual cash flow to arrive at the payback period. Alternatively, the cash flows can be subtracted from the total cost until the remainder becomes zero and the payback period determined accordingly. So long as the payback period is shorter, the project is considered as a better project to invest. In general, the firms workout some maximum allowable payback period and against which the investments are compared and the capital investment decisions are taken.

Example

“Assume the firm is considering two projects; project A and project B, each requires an investment of $100 millions. The cost of capital is 10%. Below is the summary of expected net cash flows in millions.

Payback Period

The payback from the two projects is Project A: 2 and1/3 years; Project B: 4 years”.

There are certain shortcomings associated with the payback period method. In cases where the payback period calculated in respect of some projects does not exceed the prescribed maximum payback period then the projects become acceptable.

On the other hand, if the payback period calculated exceeds the maximum period the projects will be rejected. One of the serious disadvantages with payback period is that this method does not take into account the cash flows, which result after the conclusion of the payback period. Therefore, this method lacks the quality of a perfect measure of profitability and is deceptive as such. In addition, this method suffers from another drawback in that the method fails to consider the timing during which the cash flows occurs and the quantum of cash flows during the period. This method is based on the consideration of the recovery of the cash flows for the whole period.

Despite the shortcomings, the payback method is in constant use as a support to other modern capital budgeting techniques used for evaluation. This method offers only a limited insight to the management into the risk and liquidity of a project. In respect of a firm, which is in need of immediate cash flows, this system may be found useful for assessing the periods during which the cash flows would be received from the investments made.

Since this method simply considers the cash flows without the impact of the timing and quantum of the anticipated cash flows this method cannot be expected to indicate the risks associated with the project. The payback period method when used as the project evaluation method, the firms treat it only as a necessary condition to be satisfied rather than a profitability measure (Horne, 2004 p 139).

Discounted Payback Period

Discounted payback period is exactly similar to the payback period except that instead of the actual cash flows the present values are used to calculate the payback period. It is to be noted that the discounted payback period is always longer than the regular payback period.

Even the discounted payback period suffers from some shortcomings. Even though the discounted payback period method considers the time value of the cash flows, under this method the cash flows beyond the payback periods are ignored. This kind of evaluation will lead to the rejection of projects having larger cash flows outside the maximum payback period fixed for accepting the project. Therefore, it is to be inferred that the payback period method helps the management to concentrate on the short-term profitability and in the process the profitability of the firm in the long-term resulting from the investments in the capital projects.

Internal Rate of Return (IRR)

Because of the shortcomings of the payback period method and the calculations ARR methods, the discounted cash flow method is expected to help the management to evaluate the capital investment projects in an objective basis and select the projects, which will improve the profitability of the company. The discounted cash flow method considers the quantum of cash flows and the timing during which the cash flows occur. Internal rate of return for a project can be arrived at as the discount rate, at which the present value of the anticipated cash flows meet the total value of cash outflows, which forms the capital investment in the project.

For example, consider the following data:

Initial investment $16,200
Estimated life 10 years
Annual cash inflows $ 3000
Cost of capital (minimum required of return) 10%
Set up the following equality (I = PV):
$16,200 = $3000 × PV

Then PV = $16,200/$3000 = 5.400, which stands somewhere between 12% and 14% in the 10-year line of table 4 in the back of the book. Because the investment’s IRR (13.15%) is greater than the cost of capital (10%), the investment should be accepted.

When the IRR method is used, the project will be accepted, when the IRR from the project is equated to a pre-determined cut-off rate, which is known as hurdle rate. When the IRR is equal to or exceeds the preset hurdle rate the project can be regarded as financially viable. At this point, the project will become acceptable. If the IRR does not meet the hurdle rate, the project becomes unviable and hence the project will be rejected. “Internal Rate of Return is the flip side of Net Present Value and is based on the same principles and the same math. NPV shows the value of a stream of future cash flows discounted back to the present by some percentage that represents the minimum desired rate of return, often your company’s cost of capital.” (Value Based Management.net)

The IRR method is popular because it can easily be compared with the Weighted Average Cost of Capital (WACC). However, the method suffers from certain shortcomings like the method assumes by implication that the cash inflows from the project would be invested back in the project to provide returns at IRR. This assumption may not always hold well in all the situations. The statistical method of comparing results by percentages may sometimes be misleading and may not reflect the true position (Horne, 2004, p 140).

The IRR method is difficult to calculate by hand. Therefore, the calculation of IRR is time consuming. The method however is preferred by the managers because of its support as a practical capital budgeting techniques because of its intuitive appeal. There may be some complications, which may arise in using the IRR method when there exists a non-conventional pattern. It requires the finance managers to spend more time in identifying and resolving problems with the IRR before the managers make use of the method to make a decision.

Modified Internal Rate of Return (MIRR)

Modified internal rate of return (MIRR) is a variation in the method of calculating IRR. This method makes an assumption, that the cash flows created out of a project is re-invested at the cost of the capital of the company. The cost of capital is normally assumed the WACC to the firm. This method is considered preferable to the normal IRR method because any series of cash flows has a MIRR and the MIRR takes into account the rate at which the cash generated in the project is re-invested and to this extent, this method is more scientific than the trial and error method being followed in the IRR method.

If the returns generated at the end of the life of project is taken in to account including the cash generated by the project and re-invested elsewhere, then it may become difficult for the IRR to equal the total cash generated out of the project including the re-investments. If IRR has to equal this then the returns from the project must also be invested in the same rate as IRR. However, this proposition seems to highly unrealistic and hence this method suffers a basic drawback. MIRR method also suffers from the other shortcomings of IRR method and relying on MIRR “may lead to a wrong choice” among mutually exclusive investment opportunities (Moneyterms, n.d.).

Net Present Value (NPV)

“The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project” (Investopedia, n.d.). Like the IRR method, net present value (NPV) method is also a discounted cash flow approach to capital budgeting and project evaluation. The NPV method considers the entire cash flows to be discounted to at the present value based on the the expected rate of return. When the total of the discounted cash flows is equal to zero or the total cash flows are positive, the project becomes acceptable. On the other hand, if the total of all the discounted present values is negative the project becomes unviable to be rejected. The acceptance criterion of the project may be restated in such a way that the project becomes acceptable if the total of the discounted present values is greater than the present value of the cash outflows representing the investment in the project.

The Net Present Value Method: Example

Step 1

Identify the amount and time period of each cash flow associated with a potential investment.

Initial cash outlay: $70,000

Year 1 – 4 net cash savings: $21,000 per year.

Year 5 net cash savings: $26,000.

Required rate of return: 12%.

Step 2

Discount the cash flows to their present values using a required rate of return (a.k.a. hurdle rate).

Initial outlay: $70,000 x 1.00

Year 1: $21,000 x.8929

Year 2: $21,000 x.7972

Year 3: $21,000 x.7118

Year 4: $21,000 x.6355

Year 5: $26,000 x.5674

Step 3

Evaluate the net present value–the sum of all of the cash inflows less cash outflows.

Year 0: ($70,000)

Year 1: $18,751

Year 2: $16,741

Year 3: $14,948

Year 4: $13,346

Year 5: $14,752

NPV: $ 8,538

Since the NPV of $ 8,538 is greater than $ 0, the project is acceptable.

IRR and NPV assume the same rational as the acceptance criterion for the project. When the investors expect to get a rate of return from the project, which is equal to the expected rate of return, then the investors can accept a project giving a net present value, which exceeds zero, and in this situation, there will be a rise in the stock value of the company.

The NPV method is considered less insightful since the technique does not measure the interest rates, profitability, and other benefits relative to the amount invested. This implies that NPV gives one measure of the expected dollar amount of money expected to be made from the project. Mostly, the financial managers would like to see the benefits measured on an annual basis as in the case of IRR method.

Profitability Index

The ratio of the total present value of the cash inflows as compared to the initial cash outflow representing the investment in the project represents the profitability index. The capital project becomes acceptable so long as the profitability index is more than one. Because of the similarity in calculations, the NPV method and the profitability index method provide the same kind of acceptance/rejection criterion. If a choice is to be made between mutually exclusive projects, NPV method is preferable since it expresses the economic contributions from the project in absolute terms. In contrast to this, “the profitability index expresses only the relative profitability” (Horne, 2004. p 142).

Capital Asset Pricing Model (CAPM)

This model developed by William F. Sharpe and John Lintner for the valuation of a security. This method has been adopted for the valuation of shares of a firm by many analysts due to its simplicity and the real world applicability. The relationship that exists between the risks associated with the project and the anticipated return from each project to be evaluated is considered by CAPM. Behind this model, there is the assumption that an equilibrium relationship exists between the associated risk and the anticipated return of the different projects under evaluation. Under situations of market equilibrium, a return, which is in proportion to the associated risk, is expected to result from the stock.

The risk element is inherent to the security and hence becomes unavoidable. This risk cannot be eliminated by just shuffling the investment portfolios. When the risk inherent in the investment is greater, the investors would expect a greater return, which is commensurate with the risk from the security. Thus, the relationship between the associated and unavoidable risks and the anticipated return and the valuation of securities forms the basis of the working of the CAPM model (Horne, 2004, p 62).

This model has several assumptions for its offering the proper results. The method also has lot of important consequences. “CAPM implies that investing in individual stocks is pointless, because you can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class” (Moneychimp, n.d.).

Popularity and Practice of Different Valuation Methods

Graham & Harvey, (2001) out of the survey conducted by them into the practice of project valuation methods report that most of the firms use capital budgeting techniques for the evaluation of new investments together with the payback period method. The firms prefer to use company-wide discounting rates rather than the discount rates, which are project specific for evaluating the capital investment decisions.

The survey results also show that the size of the firm happens to be one of the main factors that have influence on the practice of corporate finance. For instance fairly larger size firms are using NPV techniques and Capital Asset Pricing Model than the smaller size firms. The smaller firms are used to evaluate their projects using the payback period method. It is also observed in the study that a majority of the large firms have a tighter debt-equity ratio as compared to smaller firms.

Half of the smaller firms consider the risks involved in the projects “in doing their capital budgeting analysis “ (Block, 1997, p 294). Payne et al, (1999) have identified that the smaller firms are more likely to adjust their payback periods, while larger firms focused more on adjusting the discount rates on the project evaluations. Drury & Tayles, (1996) report 82% of the large firms often used sensitivity analysis for making capital budgeting evaluations, while 30% of the smaller firms follow sensitivity analysis. They found that 31% of the larger firms adjust the discounting rates and 9% of the smaller firms resort to this practice.

According to Drury & Tayles, (1996) in the case of smaller firms, since the employees who are involved in the making of capital project decisions would possess an expert knowledge of the proposed project, they would prefer to use simpler techniques for evaluation of the projects. On the other hand the larger companies could afford to appoint staff with more expertise in handling the sophisticated techniques of capital budgeting.

Risk Analysis is one of the important objectives of evaluating capital investments. Following the different evaluation methods for evaluating the capital investments presupposes the incorporation of the risk elements associated with the long-term investment decisions by the managers (Chadwell-Hatfield et al, 1996).

Theoretically, it is important for the firms to realign the investment opportunities with the actual cost of obtaining the required capital, which needs to be adjusted for the specific risks connected to proposed project. If the project manager ignores the consideration of the risks associated with the projects under consideration, then all the projects would present equal risks for the company. Therefore, it is for the company to apply the capital investment evaluation, which takes into account a fitting hurdle rate to achieve maximum wealth maximization. The hurdle rate is the reflection of the element of risk involved in the specific projects, in which the firm proposes to invest.

Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is recognized to act as the hurdle rate in various capital investment appraisals. Since WACC considers the cost of capital both from the equity holders and debt holders, it has been widely used by the managers. However, WACC has its own shortcomings. According to the theory, in order to use WACC as the discount rate for all the projects proposed to be considered, then it is necessary that the projects must be homogenous with respect to the risks associated with all the projects. If the risk associated with one of the projects differs substantially from others, then it becomes necessary that a specific return is assumed for that project (Kester et al, 1999).

Role of Post-Completion Auditing in Capital Budgeting

The objective of post-completion audit is to evaluate the efficiency and effectiveness of the capital budgeting decisions, which the management has implemented. The post-completion audit compares the planned and actual outcomes of the projects handled, costs and the use of resources involved in the project, and the results and benefits derived from the investment in the capital projects. The audit takes into account all the assumptions made while making the evaluation of various capital budgeting proposals.

The post-completion audit represents an ongoing process, which enables the organization to learn from the mistakes and improve upon them. It may so happen that the weakness found during the post audit might be relating to one specific project or to the capital budgeting decisions of the organization as a whole. In case, where the weakness relates to the system of capital budgeting , the auditor has to report to the management on the need for overhauling the system by improving on the weaknesses.

Thus, the purpose of a post completion review is to support a continuous improvement in the capital investment and implementation process with a view to strengthen the capital evaluation system for the future to allow for the identification and implementation of corrective actions on the project under review or in similar projects. This provides the company a chance to review the current cash flows of a project on the date of review as well as the updated future cash flows of that project to allow for a review of current procedures and to design and implement a better one to improve future decisions. This guarantees better implementation and better conformance (Malaysian Institute of Accountants, n.d.).

There are three different components of the post-completion review irrespective of whether the review is a post investment review or an outcome review. The components are

  1. the decision review,
  2. the planning and budgeting assumptions and process review and
  3. the performance review dealing with the implementation and above all the review of the outcome of the investment in the specific project.

The post completion review can be considered as a positive and forward-looking technique. A well-designed review would be able to identify the individual who may appear to be responsible for deviations from forecast. It is the function of the the completion review team to determine the reasons for the occurrence of the deviations and not the people who could be blamed for such weaknesses. Once the team determines the cause(s) for the deviation there is the need to take a key step for correcting the action for the future. The post completion audit aims to collect factual and quantifiable data and information.

If the role of management is assumed to work towards increasing the shareholder value, it would be helpful for the managers to predict in advance the impact of their financial decisions. By adopting, any of the above capital project evaluation methods the managers would be able to provide effective financial decisions; of course, subject to the considerations of the size of the firms, amount of investments and the shortcomings of each of the methods described. The capital budgeting decisions are always tricky in that if the company invests too much on a wrong project it will lead to high costs, depreciation and other expenses.

On the other hand if the company fails to take appropriate capital expenditure decisions at the time when they have to be taken, it may have an adverse effect on sustaining the sales and profitability growth of the company. The company may miss several profitable opportunities that otherwise would be available to the firm and thus it would affect the firm’s competitive strength. Similarly, if the firm does not enhance its production capacity by making proper investments in latest technology and equipments, it is highly likely that the company may lose its major market share to the competitors.

The foremost consideration for making capital budgeting decision is that such decisions are to be made after taking into account not all the factors affecting the decision as the decision once taken can be reversed easily. Since the capital budgeting decisions are difficult to evaluate the organization should take those decisions within a strategic framework. Depending on the nature and size of proposed investments, different capital budgeting techniques can be considered for evaluating the capital investment decisions. It is also vitally important that the managers study the relative merits and demerits of each technique and apply one, which is appropriate for the investment to be reviewed.

The managers should also take care in arriving at the hurdle rate, which is one of the main considerations in evaluating the capital budgeting decisions. If the hurdle rate is not determined properly, it may lead to the decision of rejecting projects, which are otherwise acceptable. In some cases, if the hurdle rate is low, the capital expenditure decision of the firm may result in a loss to the organization.

The managers should also ensure that the wealth maximization for the stockholders is given prominence in evaluating the capital decisions. To ensure this the managers should select those projects which results in positive Net Present Value if the company follows the NPV technique or select the project with the lowest payback period when the payback period method is followed for evaluating the capital investment decisions.

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