The Basics of Capital Budgeting

Introduction

The long-term viability of investment projects to be undertaken is critical to the success of any company. This is the reason why companies evaluate all new investment projects in order to determine their suitability.

These projects are evaluated on their profitability, duration etc. There are several methods of evaluating investment projects. Some of these methods include:

  • Payback period
  • Net present value
  • Internal Rate of return
  • Modified internal rate of return

Main text

Capital projects usually involve the commitment of substantial resources and affect the company’s financial position to a large extent. Therefore these projects should be carefully evaluated to establish if they meet the company’s set minimum requirements.

In evolving capital investments, accounting profit is not used cash flows are used instead. The project cash flows can be normal or nonnormal.

Normal cash flow is where the project start with cash outflows and later on the project generates positive cash flows.

Non-normal cash flows on the other hand are witnessed when the project oscillates between negative and positive cash flows (Boise State University 2008).

Payback period

This is the duration or period that it takes the company to recover its initial investment (capital). It is basically the period that it takes the company to break even.

Adding the cash flows generated by the project until it equals the initial investment arrives at the payback period.

The decision criterion in the payback period method is to accept projects that have lower payback periods (Boise State University 2008).

Working

Initial cost = $1,300,000

Cash flows year 1 500,000

Year 2 350,000

Year 3 450,000

1,300,000

In the 3rd year, the payback period is attained before utilizing full-year cash flows and hence to arrive at the exact period, it is assumed that the cash flows are earned uniformly throughout the year.

Therefore the number of months = 450 X 12 months

475,000

Therefore the payback period = 2 years 11 months

In determining the payback period, discounted cash flows can also be used.

Advantages

This method of evaluating capital projects is relatively easy to calculate and understand such that even an ordinary person who is not an expert in finance can calculate.

Payback period is able to consider the project’s liquidity and risk. This is because the cash flows are added to determine the payback period. Projects that generate more negative cash flows have longer payback periods and hence are risky.

The same case applies to liquidity.

Projects with more negative cashflows indicate that they are not feasible in terms of liquidity (nettle@Africa 2008).

Disadvantages

Despite its relative ease of use, this method has some serious drawbacks.

Key among these are: –

Payback period does not consider the time value of money, which is an important aspect of finance. The method just adds the cash flows without considering their timing. Although the timing of the cash flows can be considered by modifying the formula and hence using discounted cash flows instead of basic cash flows.

The method just considers the cash flows before the payback period. All other cash flows after that are ignored.

This is a serious flaw in the sense that a company may accept a project with shorter period but with negative cash flows after the payback period (nettle@Africa 2008).

Net present Value

This is the difference between the discounted project cash inflows and the initial cost. The cash flows are discounted using the firm’s overall discounting rate or rate used for similar projects.

This method recognizes the time value of money. Money received one year from now that would have otherwise have been received now is probably worthless. Therefore the projects cash flows should be discounted to present terms to establish the real returns that will be generated by the project (Vince 2002)

In establishing which discounting rate to be used, the company should ensure that the correct rate is used because any change in such rate affects the nature of NPV because of using a wrong discounting rate.

The decision rule in NPV is to accept a project with positive NPV i.e. NPV>0 for independent projects while mutually exclusive projects with higher NPVs are accepted. Projects with NPV=0 make the investor indifferent as to accept or reject. The nature of cash flow i.e. annuity, single, due is also considered (Vince 2002)

Workings

NPV = project cash inflows – project cash outflow

n

NPV = ∑ CFn

n=0 (l+r) n

Initial cost = $1,300,000

Cash flows

Period Cash flow Discounting factor (PVIFn6%) NPV

0

(1,300,000) 1 (1,300,000)

1 550,000 0.9434 471,700

2 350,000 0.8900 311,500

3 475,000 0.8396 398,810

4 450,000 0.7921 356,810

5 300,000 0.7473 224,190 NPV 462,645

Advantages

One of the most important benefits of using NPV to evaluate project is that it considers the time value of money. The future cash flows are discounted to present values so as to establish what they are worth now.

From the concept of the timing of the cash flows, the idea of the opportunity cost is considered. The cash flows are discounted to current values so that they can be compared with other available investment opportunities. This basically means that a project to be accepted should provide more returns than the opportunity cost.

The nature of the cash flows generated by the project is also considered.

Positive cash flows will lead to positive NPVs. The discounting ensures that the cash flows used in decision-making have taken into consideration the possible changes caused by volatility in interest rates.

Changes in interest rates can severally affect the project’s cash flows (nettle@Africa 2008).

Disadvantages

The discounting rate used in NPV should be accurately determined because the use of a wrong rate can lead to acceptance of a project, which is not profitable. Net present value is affected by the discounting rate used.

The NPV criterion also has another disadvantage of not considering the qualitative aspects of the project. The acceptance of the project should not only be based on quantitative factors like profitability. Otherwise a project with positive NPV but does not meet the company’s qualitative criteria may be accepted. Otherwise a project with positive NPV but does not meet the company qualitative criteria may be accepted.

Internal Rate of Return (IRR)

This is the rate at which the NPV=0. The IRR formula

n

= ∑ Cfn = 0 the r is the IRR

n=0 (1+r) n

An investment with IRR more than the company’s required rate of return should be accepted.

Therefore projects with IRR higher than the cost of capital are accepted.

Independent projects with IRR more than the cost of capital should be undertaken while for mutually exclusive projects, the company will have to accept projects with higher IRR.

The IRR based on trial and error method is approximately 19%.

Advantages

IRR uses all the project cash flows compared to methods like payback period, which ignore cash flows after payback period. The use of cash flows ensures an accurate analysis of the project (Vince 2002)

This method also leads to the acceptance of projects, which have returns above the cost of capital. Therefore, the use of IRR ensures that all accepted projects have returns higher than cost of capital.

Time value of money is also incorporated in this method through the discounting of the cash flows.

Apart from all the above, IRR also takes into consideration the quantitative aspects of the project.

Disadvantages

A project can have many IRR points and therefore choosing the right IRR may be difficult. This is one of the disadvantages of this method.

IRR also may conflict with other investment appraisal techniques like NPV i.e. NPV may lead to an accepted project but the IRR indicates a rejection (Vince 2002)

Compared to NPV, it does not indicate the monetary increment by the project and therefore may not be appropriate in selecting mutually exclusive projects.

Modified Internal Rate of Return

As seen earlier, a project can lead to multiple IRR and therefore, decision-making is difficult. This problem led to the development of MIRR. MIRR uses cash flows in evaluating projects (nettle@Africa 2008).

MIRR is that point where the future cash flows at the end of the project are equal to the initial investment. All the cash flows except the cash outlay are used to get the terminal value (Vince 2002)

Working

Period Amount discounting rate (6%) Future value

1 500,000 1.2625 631,250

2 350,000 1.1910 416,856

3 475,000 1.1236 533,710

4 450,000 1.06 477,000

5 300,000 1 300,000

FV 2,358,816

The future value (terminal value) is then discounted to year 0 i.e.

2,358,816X(1.06) –5 =1,762,645. This amount is more than the initial capital outlay and therefore we try another rate e.g. 20%

Period Amount Factor (20%) future Value

1 500,000 2.0736 1,036,800

2 350,000 1.728 604,800

3 475,000 1.44 648,000

4 450,000 1.2 540,000

5 300,000 1 300,000

Future value 3,129,600

Discounting 3,129,600 to period 0 results into 1,257,716. This amount is lower than the initial outlay and therefore to get the MIRR we use interpolation method (Vince 2002)

= Trial 2 – Trial 1 = Initial Cost – Trial 1

MIRR 2 – MIRR1 MIRR – MIRR 1

= 1,257,716- 1,762,64 = 1,300,000 – 1,762,645

20% – 6% MIRR – 6%

MIRR = 18.83%

Advantages

The use of MIRR enables the comparison of the current project with other similar investments and thus facilitating better investment decisions (Vince 2002)

It also considers the time value of money and avoids the situation of multiple IRR.

Disadvantages

It is very complex and hard to calculate hence cannot be used by everybody.

Recommendation

The project should be accepted based on the NPV, RR and MIRR criteria. The project has positive NPV. Both the IRR and MIRR are more than the cost of capital and required rate of return.

The payback period method requires that the company accepts projects with shorter payback periods when compared to similar projects.

Reference

nettle@Africa (2008). Project Evaluation and Selection Analysis Techniques. Web.

Boise State University (2008). Chapter 10. The Basics of Capital Budgeting. Web.

Vince, D., E. (2002) Financial Analysis and Decision Making. Tools and Techniques to Solve Financial Problems and Make Effective Business Decisions. Capital Budgeting. Mc Graw Hill.