Capital Budgeting

Concept of Capital Budgeting

Capital budgeting is primarily concerned with how a firm makes decisions on sizable investments in long-lived projects to achieve the firm’s overall goal.

This is the decision area of financial management that establishes criteria for investing resources in long-term real assets. Investment decisions (on sizable long-term projects) today will determine the firm’s strategic position many years hence, and fix the future course of the firm.

Funds are invested in both short-term and long-term assets. Capital budgeting is primarily concerned with sizable investments in long-term assets.

These assets may be tangible items such as property, plant or equipment or intangible ones such as new technology, patents or trademarks. Investments in processes such as research, design, development and testing – through which new technology and new products are created – may also be viewed as investments in intangible assets.

The capital budgeting process

Capital budgeting is a multi-faceted activity. There are several sequential stages in the process. For typical investment proposals of a large corporation, the distinctive stages in the capital budgeting process are depicted, in the form of a highly simplified flow chart.

Rate of return
The rate of return (ROR) is a basic concept in finance. If there are only two cash flows, a cash outlay or an investment at the beginning of the year and a cash inflow or the realization of the investment at the end of the year, the rate of return is usually measured by:

RoR formula in capital budgeting

The symbol, r, used for the discount rate is also employed for the rate of return to alert the reader that the discount rate is a rate of return.

Example
Suppose you invest $1,000 at the beginning of the year and receive a total of $1,100 at the end of the year. The rate of return is:

Rate of return example

Net present value
The net present value model is the only decision technique which links the goal of the firm to the calculated output. The calculated NPV is the actual dollar amount by which the firms current wealth will increase if the project is undertaken.

Its calculation accounts for the time value of money at the required rate of return, and uses this as a data input, rather than as a decision output. The weaknesses and problems of the other three criteria, as discussed in the following three sections, demonstrate the superiority of the NPV criterion.

Internal rate of return
The IRR is the financial equivalent of an algebraic problem. The problem is: given a value for Y, what is the solution for x in the following equation?

Internal rate of return formula

This geometric progression has the same structure as a set of discounted cash flows, where the numerator of the equation is the set of cash flows, and the x value is an interest rate. In algebra this equation has meaning.

Unfortunately, when it is transferred to finance it is not economically relevant. In finance, the role of x cannot be clearly defined. In the NPV model, the NPV is clearly defined. In the IRR equation, however, it is difficult to define IRR in its own terms, because it effectively means something like: ‘the rate of return at which all funds, if borrowed at the IRR, could be repaid from the project, without the firm having to make any cash contribution’.

The IRR criterion does not measure the project’s contribution to the firm’s value.
The IRR remains in use because decision-makers are used to dealing in ‘rates of return’ rather than the more esoteric NPV. The IRR measure is useful for easily comparing the rate of return from the project being considered with various alternative returns.

There are a number of conceptual and computational problems with using IRR.

For example, the IRR calculation implicitly assumes that cash earned can be reinvested at the calculated IRR. The NPV calculation employs this assumption too, but it is probably more tenable there as it is likely that investment opportunities will be available at the general required rate of return, more so than at the unique IRR.

A ‘modified IRR‘ (MIRR) has been developed to overcome this problem. The modified IRR computational measure allows for a ‘reinvestment rate‘ to be input to the calculation to derive the MIRR.

The resulting MIRR figure may be defined as ‘the earning rate of the project if it is assumed that funds when received are reinvested at the forecast reinvestment rate’.

The IRR decision can also conflict with the NPV decision for certain projects. This conflict is especially important where only one from two or more mutually competing projects can be selected.

For example, let us assume Project A has cash flows of −$2,000, $200, +$3,700 and Project B has cash flows of −$2,000, +$2,000 and +$1,480. The two projects differ only in the timing of the cash inflows; their initial outlays and overall lives are similar. Both have a required rate of return of 9% per annum. The outcomes from these two projects are:

IRR example in capital budgeting

The ranking conflict between the NPV and the IRR for competing projects can be highlighted in an NPV profile chart.

NPV profile chart

This chart shows the NPVs of both projects at various required rates of return (discount rates). The NPV schedules intersect at one point. This crossover point is known formally as the ‘Fisher Intersection’.

In this particular case this value is given as approximately 23%. If the appropriate discount rate happens to be lower than this crossover rate, there is a conflict in project ranking between NPV and IRR.

For example, a discount rate of 9% will produce conflicting rankings under the two criteria. The NPV criterion ranks A above B while the IRR criterion ranks B above A. If the appropriate discount rate happens to be higher than the crossover point, for example 35%, then both criteria produce the same ranking – B is preferred to A.

Payback period
Payback period (PP) is a measure of the time taken to recoup the initial outlay. Suppose for example that Project C has the following yearly cash flows: −$280, +$120, $140, −$60, +$90. The progressive sum of the cash flows after the initial outlay is: $120, $260, $200, $290. The payback occurs in year 4. There are several problems with this measure:

The cash flows are not discounted. As the time value of money is not taken into account, the future cash flows cannot be related to the initial outlay.

The data outcome ‘four years’ is not a decision variable. It does not relate to the firm’s goal of wealth maximization.

There is no objective measure of what constitutes an acceptable payback period. Management may set an ad hoc target of say three years, but this value is not objectively related to the firm’s goal.

Cash flows occurring after the payback period are ignored. In the case where large outflows may occur on the termination of the project, such as the cost of rehabilitation of a mine site, a project may be erroneously accepted on the basis of a short payback term.

Accounting rate of return
The accounting rate of return (ARR) is the ratio of average accounting income to investment value. For example, suppose we have an initial outlay of $200, and subsequent annual accounting income figures of $80, $110, $70 and $120.

The average annual accounting income would be (80 + 110 + 70 + 120)/ 4 = $95, and the ARR would equal 95/200, or 47.5%.Unfortunately, there are several variations on this simple measure. The divisor can take on several meanings and values.

Examples of three of these are:

Average of opening and closing book-values. With an opening book-value of $200, we might assume a closing written down book-value of $40. The ‘average’ value thus committed to the investment is (200 + 40)/2 = $120. The ARR is thus 95/120, or 79.16%.

Average of net opening and closing book-values. Given the values of $200 and $40, the ‘net’ average value is (200 − 40)/2 = $80, and thus the ARR is $95/80, or 118.75%.

Average of progressive written down book-values. Written down book-values at the end of each year are: $160, $120, $80 and $40. The average is (160 + 120 + 80 + 40)/ 4 = $100, and thus the ARR is 95/100, or 95%.

Capital budgeting decision is an important, crucial and critical business decision due to :

1) substantial expenditure :
capital budgeting decision involves the investment of substantial amount of funds and is thus it is necessary for a firm to make such decision after a thoughtful consideration, so as to result in profitable use of scarce resources. Hasty and incorrect decisions would not only result in huge losses but would also account for failure of the firm.

2) long time period :
capital budgeting decision has its effect over a long period of time, they affect the future benefits and also the firm and influence the rate and direction of growth of the firm.

3) irreversibility:
most of such decisions are irreversible, once taken, the firm may not been in a position to reverse its impact. This may be due to the reason, that it is difficult to find a buyer for second-hand capital items.

4) complex decision : capital investment decision involves an assessment of future events, which in fact are difficult to predict, further, it is difficult to estimate in quantitative terms all benefits or costs relating to a particular investment decision.

various types of capital investment decisions :

There are various ways to classify capital budgeting decisions, generally they are classified as :

1) on the basis of the firm’s existence :
capital budgeting decisions are taken by both newly incorporated and existing firms. New firms may require to take decision in respect of selection of plant to be installed, while existing firms may require to take decision to meet the requirements of new environment or to face challenges of competition.

These decisions may be classified into:

  • Replacement and modernisation decisions : replacement and modernization decisions aims to improve operating efficiency and reduce costs. Usually, plants require replacement due to they been economically dead i.e. no more economic life left or on they becoming technologically outdated. The former decision is of replacement and latter one of modernization , however, both these decisions are cost reduction decisions.
  • Expansion decision : existing successful firms may experience growth in demand of the product and may experience shortage or delay in delivery due to inadequate production facilities and thus, would consider proposals to add capacity to existing product lines.
  • Diversification decisions :these decisions require evaluation proposals to diversify into new product lines, new markets, etc. to reduce risk of failure by dealing in different products or operating in several markets. expansion and diversification decisions are revenue expansion decisions.

2) on the basis of decision situation :

  • Mutually exclusive decisions : decisions are said to be mutually exclusive when two or more alternative proposals are such that acceptance of one would exclude the acceptance of the other.
  • Accept-Reject decisions : the accept-eject decisions occurs when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which have a higher return than certain desired rate of return are accepted and rest rejected.
  • Contingent decisions : contingent decisions are dependable proposals, investment in one requires investment in another.

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