What is “Capital Budgeting”?
Capital budgeting is a process undertaken by a business to evaluate potential major projects or investments. It involves determining which proposed fixed asset investments it should accept or decline.
The process paints a comprehensive quantitative picture of each proposed project or investment, thereby providing a rational basis for making a judgment. Big, expensive projects such as the construction of a new plant, will usually have to go through the capital budgeting process in order to determine whether or not the company should proceed with the project. This process is sometimes called an investment appraisal.
Key Learning Points
- Capital budgeting is the process by which companies determine the value of a potential investment or project
- The most common methods of capital budgeting used by businesses are payback period, internal rate of return, and net present value
- The payback period highlights the time it takes for the cash flows from a project to equal the initial investment, with a shorter period being preferable
- The internal rate of return is the discount rate that returns a net present value of 0 and is often compared to the cost of capital to inform decision making
- The net present value reveals the potential profitability of a project by comparing the sum of the present value of its future cash flows to its initial outlay
Understanding Capital Budgeting
Capital budgeting refers to the decision-making process businesses undertake to decide which capital-intensive projects should be approved or rejected: business ventures, investments, or projects which enhance shareholder value present attractive opportunities for businesses. However, for a company to pursue such opportunities or ventures, it has to evaluate the viability of each potential project because the capital available to any business is limited.
Capital budgeting creates a system of accountability and measurability for approaching projects and investments involving large cash outlays. Businesses can estimate the potential risks and returns involved in a project before deciding to commence the project.
The goal of a business is to create value for its shareholders, which is achieved by assuring its sustained profitability. Responsible companies employ capital budgeting to guide decision-making on investments and projects that have long-term economic and financial implications. By deciding to take on a particular project, a business is not only making a financial commitment but is also investing in its long-term direction, which will undoubtedly affect its future.
As a result, companies employ different project evaluation methods such as internal rate of return, payback period, net present value, and discounted cash flow analysis to determine which projects will yield the best return.
Capital Budgeting Methods
The payback period analysis determines the length of time required to generate sufficient cash flow from a project to pay for the initial investment in it. It calculates how long it takes to recoup the original investment. It is the simplest form of capital budgeting analysis and the least accurate.
Calculating the payback period involves calculating the average annual cash inflows resulting from a project or investment and dividing the initial investment by that average. The resulting number shows the length of time to recoup the initial investment. For example, if a 5-year project requires a $1 000 000 initial investment and has annual cash inflows of $300 000, the payback period will be three years and four months. When comparing projects, the one with the shorter payback period is preferred to that with a longer payback period.
It is easy to calculate once the cash flow forecasts have been determined and is usually used when companies have a limited amount of liquidity for investing and need to figure out how quickly they can recover the original investment and undertake subsequent projects.
One of the disadvantages of the payback period is that it ignores the time value of money, which is a vital principle of finance. This issue can be overcome by discounting the cash flows to arrive at a discounted payback period. In addition, the payback period ignores any cash flows occurring towards the end of a project. Assume two projects, A and B, with payback periods of 3 and 4 years respectively. The payback period analysis favors project A. However, if there is a substantially large inflow at the end of project B, making it more valuable than A, then decision-makers will be wrongly informed using the payback period method.
Internal Rate of Return
The internal rate of return (IRR) or expected return on a project refers to the discount rate that would return a net present value of zero. The IRR is the rate that equates the initial investment to the present value of the future cash flows from an investment. In other words, it is the expected compound annual rate of return that will be earned on an investment or project. In order to decide on whether to approve or reject a project based on this metric, the IRR is compared to the actual rate used by a business to discount after-tax cash flows or its hurdle rate.
If the internal rate of return from a project is higher than the weighted average cost of capital (WACC), then the project is profitable and should be accepted. On the other hand, if the IRR is less than the WACC, it should be rejected because it is not profitable.
The internal rate of return provides a yardstick for assessing all potential projects a company can undertake with respect to its capital structure. It allows companies to compare projects based on returns on invested capital. This is because the hurdle rate which the IRR is compared to for decision making is the weighted average cost of capital or the cost of capital of a company. The WACC represents the proportions of the costs of a company’s various sources of capital.
However, the internal rate of return does not allow for an appropriate comparison of mutually exclusive projects. It only provides a benchmark figure for what projects are worthwhile for a business based on its cost of capital but does not capture a true sense of the value that a project will add to a firm. This implies that presented with a choice between two projects, the IRR can show that both are beneficial to the company but does not show which is best among both options.
Net Present Value
The net present value (NPV) represents the present value of all the future cash flows, both positive and negative, over the life of an investment. The NPV approach is the most intuitive and accurate valuation method of capital budgeting. It takes all the cash flows occurring during the life of a project except the initial cash outlay and discounts them back to the current date. The result of this process is the NPV. The reason for discounting these cash flows is to highlight the time value of money, which implies an amount of money today is worth more than the same amount in the future. The discount rate used here is the weighted average cost of capital.
The acceptance criteria for any investment when using the net present value approach states that all projects with a positive NPV should be approved while those with negative NPVs should be rejected. When comparing projects of which only one can be selected due to limited liquidity, the project with the most positive NPV should be chosen.
Assume the weighted average cost of capital for ABC Incorporated in 10%. ABC Incorporated must compare two potential projects, A and B, both requiring a $1 000 000 initial investment, and having a lifespan of 5 years but varying cash flows.
As shown above, the net present values from projects A and B are $5 363 060 and $7 663 325. The NPVs show that both projects will positively affect the company’s value. However, if ABC Incorporated had only $1 000 000 available for investment at the moment, project B is superior as it returns a greater NPV.
The net present value provides a measure of added profitability to be realized from a given project or investment. It also makes room for the comparison of mutually exclusive projects simultaneously. A sensitivity analysis can also be used in the NPV calculations to evaluate different scenarios with differing discount rates.
The criticism faced by using the net present value method is that it does not factor in the overall magnitude of a project. A quick fix to this problem is calculating the profitability index (PI). The PI is calculated by dividing the present value of future cash flows by the initial investment. A PI greater than 1 shows that the NPV is positive, while a PI of less than 1 indicates a negative NPV.
Capital budgeting is vital when making investment decisions involving significant capital outlays, which may lead to bankruptcy if the investment fails. It is a mandatory activity for big capex decisions which may have longer-term economic and financial implications on the future of a business. The best practice is to use all the methods of capital budgeting together to assess potential investments with respect to the overall business strategy of the company.