Introduction to Capital Budgeting

Defining Capital Budgeting

Read this introduction to capital budgeting. Make sure you can compare different capital budget methods, describe the goals of the capital budgeting process, identify various sources of cash flow within an organization, analyze and rank investment proposals, identify reinvestment assumptions of different capital budgeting methods, and classify short-term and long-term financing methods.

Capital budgeting, which is also called "investment appraisal," is the planning process used to determine which of 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 to budget for major capital investments or expenditures.

Major Methods

Many formal methods are used in capital budgeting, including the techniques as follows:

Net present value
Internal rate of return
Payback period
Profitability index
Equivalent annuity
Real options analysis

Net Present Value

Net present value (NPV) is used to estimate each potential project's value by using a discounted cash flow (DCF) valuation. This valuation requires estimating the size and timing of all the incremental cash flows from the project. The NPV rate greatly affects the discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making the right decision.

This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must consider the financing mix. Managers may use models, such as the CAPM or the APT, to estimate a discount rate appropriate for each particular project and use the weighted average cost of capital(WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

Internal Rate of Return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR, which is often used, may select a project with a lower NPV.

One shortcoming of the IRR method is that it is commonly misunderstood when conveying an investment's actual annual profitability. Accordingly, a measure called "Modified Internal Rate of Return (MIRR)" is often used.

Payback Period

In capital budgeting, the payback period refers to the period of time required for the return on an investment to "repay" the sum of the original investment. The payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods.

The payback period is considered a method of analysis with serious limitations and qualifications because it does not account for the time value of money, risk, financing, or other important considerations, such as opportunity cost.

Profitability Index

The profitability index (PI), also known as the profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

Equivalent Annuity

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of seven years, and project B has an expected lifetime of 11 years, it would be improper to simply compare the net present values (NPVs) of the two projects unless the projects could not be repeated.

Real Options Analysis

The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. However, managers will have many choices of how to increase future cash inflows or to decrease future cash outflows. In other words, managers get to manage the projects, not simply accept or reject them. Real options analysis tries to value the choices–the option value–that the managers will have in the future and adds these values to the NPV.

These methods use the incremental cash flows from each potential investment or project. Techniques based on accounting earnings and accounting rules are sometimes used. Simplified and hybrid methods, such as payback periods and discounted payback periods, are also used.

Key Points

Capital budgeting, which is also called investment appraisal, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing.
Major methods for capital budgeting include Net present value, Internal rate of return, Payback period, Profitability index, Equivalent annuity and Real options analysis.
The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment; Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR may select a project with a lower NPV.

Terms

Modified Internal Rate of Return – the modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.
APT – in finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

Example

Payback period: For example, a 1000 investment which returned 500 per year would have a two year payback period. The time value of money is not taken into account.

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