Unit 6: Capital Budgeting Techniques


6a. Explain the purpose of capital budgeting techniques

  • How do firms use money from their capital budgets to invest?
  • What is a "project" to a firm?
  • How do firms decide which projects to invest in?

Firms have finite financial resources and must make capital budgeting (the process of evaluating, planning, and selecting long-term investment opportunities that require significant financial resources) decisions about capital investments. Capital investments are called projects (specific investment opportunities or initiatives that require substantial financial commitment and are expected to generate returns over multiple periods). Firms have to choose which projects to invest in by ranking projects based on the outcome of capital budgeting techniques. To do so, they use project evaluation criteria.

The most common project evaluation criteria of capital budgeting are net present value (NPV) and internal rate of return (IRR). However, there are others, such as the payback period or the profitability index. Each capital budgeting technique has its own decision criteria that must be considered after calculating the return. Capital budgeting decision tools allow a company to invest capital in a manner that will maximize shareholder value.

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6b. Calculate the NPV, Payback, Profitability Index, and IRR of investment options

  • How do you calculate NPV?
  • How do you calculate the payback period?
  • How do you calculate the profitability index?
  • How do you calculate IRR?

Net present value uses a technique called discounted cash flow valuation, which is a financial analysis method that estimates the value of an investment by calculating the present value of its expected future cash flows, using a discount rate to account for the time value of money and risk. Net present value (NPV) is a variation on the present value calculation that allows for calculating both cash inflows and outflows and changing discount rates and maturities. The initial investment for the project is subtracted from the PV of the expected future cash flows. The decision criteria for an NPV calculation are as follows:

  • If the NPV > 0, accept the project.
  • If the NPV < 0, reject the project.
  • If the NPV = 0, accept or reject the project based on preference or other factors.

If more than one project has a positive NPV (an NPV > 0), the project with the highest NPV should be accepted.

Payback period is a capital budgeting metric that measures the amount of time it takes for an investment to recover its initial cost from the cash inflows it generates.

Payback period = Amount to be initially invested / Estimated annual net cash inflow

The payback period does not consider the time value of money. It also does not account for cash flows that occur after the payback period. Accept a project if the payback period is less than the required payback; reject if it is greater.

Profitability index (PI) = PV of future cash flows / Initial investment

As the value of the profitability index increases, so does the financial attractiveness of the proposed project. Rules for selection or rejection of a project:

  • If PI > 1, then accept the project
  • If PI < 1, then reject the project

The internal rate of return (IRR) on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero. In more specific terms, the IRR of an investment is the discount rate when the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. A project should be accepted if the IRR is greater than the required return.

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6c. Discuss capital budgeting methods and their effectiveness in making sound investment decisions

  • What are the pros and cons of the main capital budgeting methods?
  • Which decision technique is most accurate?
  • Why is it important to use multiple capital budgeting methods when evaluating a project?

The IRR method is easily understood and considers the time value of money. However, the IRR can't be used when evaluating mutually exclusive projects or those of different durations. The payback period is easily calculated and easy to understand. However, it does not take into account the time value of money.

The profitability index translates the amount of value created per unit of investment. It is therefore useful for ranking projects. It does not directly show the amount of value created. NPV is considered the most accurate capital budgeting method. It directly shows the increase in value resulting from the project, considers the time value of money, and does not have the limitations associated with the other methods. NPV requires an accurate discount rate; may be harder to understand for non-finance stakeholders; and does not show return as a percentage.

Using multiple capital budgeting methods when evaluating a project is important because it provides a more complete, balanced, and reliable assessment of the project's financial viability. Each method has unique strengths and weaknesses, and using several together can compensate for individual limitations.

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6d. Discuss cash flow analysis and other factors when making capital budgeting decisions

  • What types of cash flows are relevant in capital budgeting analysis?
  • How do we utilize the incremental approach in capital budgeting?
  • How are sunk costs and opportunity costs treated in capital budgeting?

In capital budgeting, only relevant cash flows, those that are directly affected by the investment decision, should be included in the analysis. These are the cash flows that help determine whether a project will add value to the firm. Since capital budgeting aims to assess future value creation, only incremental, forward-looking, cash-based flows matter.

The incremental cost approach is optimal to use when comparing only two projects. It focuses on both cost increases and decreases. Only those costs and revenues that differ between the two projects being considered are the costs and revenues discounted cash flow analysis needs to be applied. The final result of an incremental NPV analysis should be the same as the final result from using the total cost approach of NPV, which is the more common approach.

Sunk costs are costs that have already been incurred and cannot be recovered, regardless of whether the project goes forward or not. Opportunity costs represent the benefits foregone by choosing one alternative over another. In capital budgeting, both sunk costs and opportunity costs are important, but are treated very differently. Sunk costs are ignored in capital budgeting decisions and are not included in the analysis of project cash flows. Opportunity costs are included in capital budgeting analysis, and they are considered relevant costs because they represent real trade-offs.

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Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • capital budgeting
  • discounted cash flow valuation
  • incremental cost approach
  • internal rate of return (IRR)
  • net present value (NPV)
  • opportunity cost
  • payback period
  • profitability index (PI)
  • project
  • sunk cost
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