# Capital Budgeting - Explained

What is Capital Budgeting?

# What is Capital Budgeting?

Capital budgeting refers to the process in which a business ascertains and evaluates possible large investments or expenses. These investments and expenditures comprise projects like investing in a long-term venture or building a new plant.

Most times, a company evaluates the lifetime cash inflows and outflows of a prospective project to ascertain if the potential returns gotten meet the desired target benchmark, also referred to as "investment appraisal."

## Capital Budgeting Decisions

The process of analyzing and deciding which long-term investments to make is called a capital budgeting decision, also known as a capital expenditure decision.

Capital budgeting decisions involve using company funds (capital) to invest in long-term assets.

When looking at capital budgeting decisions that affect future years, we must consider the time value of money.

The time value of money concept is the premise that a dollar received today is worth more than a dollar received in the future.

For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars.

The term cash flow refers to the amount of cash received or paid at a specific point in time.

The term present value describes the value of future cash flows (both in and out) in today’s dollars.

When managers evaluate investments in long-term assets, they want to know how much cash would be spent on the investment and how much cash would be received as a result of the investment.

The investment proposal is likely rejected if cash inflows do not exceed cash outflows.

We use two methods to evaluate long-term investments, both of which consider the time value of money.

The first is called the net present value (NPV) method, and the second is called the internal rate of return method.

## The Present Value Formula

One equation can be used to find the present value of a future cash flow.

The equation is

P= F(1+r) n

where

P = Present value of an amount

F= Amount received years in the future

= Annual interest rate

= Number of years

## Present Value Tables

You can also use the present value tables.

In these tables, the present value = the amount received in the future × the Present value factor.

## How Does Capital Budgeting Work?

Typically, businesses should pursue every project and opportunity which improves shareholder value. However, because there is a limitation to the amount of capital available for new projects, management needs to utilize capital budgeting strategies in determining which projects would yield the highest return obedience an applicable timeframe.

Various capital budgeting methods exist including net present value, discounted cash flow, payback period, throughput analysis, and internal rate of return.

## Capital Budgeting with Net Present Value

Present value calculations tell us the value of cash flows in today’s dollars.

The NPV method adds the present value of all cash inflows and subtracts the present value of all cash outflows related to a long-term investment.

If the NPV is greater than or equal to zero, accept the investment; otherwise, reject the investment.

This information helps companies to evaluate long-term investments.Managers adjust for the timing differences related to future cash flows?

Most managers use the NPV approach. This approach requires three steps to evaluate an investment:

Step 1. Identify the amount and timing of the cash flows required over the life of the investment.

Step 2. Establish an appropriate interest rate to be used for evaluating the investment, typically called the required rate of return(This rate is also called the discount rate or hurdle rate.)

Step 3. Calculate and evaluate the NPV of the investment. Although managers often estimate the interest rate, this estimate is typically based on the organization’s cost of capital.

The cost of capital is the weighted average costs associated with debt and equity used to fund long-term investments.  The cost of debt is simply the interest rate associated with the debt (e.g., interest for bank loans or bonds issued).

The cost of equity is more difficult to determine and represents the return required by owners of the organization.

The weighted average of these two sources of capital represents the cost of capital (finance textbooks address the complexities of this calculation in more detail).

The general rule is the higher the risk of the investment, the higher the required rate of return (assume required rate of return is synonymous with interest rate for the purpose of calculating the NPV).

A firm evaluating a long-term investment with risk similar to the firm’s average risk will typically use the cost of capital.

However, if a long-term investment carries higher than average risk for the firm, the firm will use a required rate of return higher than the cost of capital.

### The NPV Rule

Managers apply the following rule to decide whether to proceed with the investment:

NPV Rule: If the NPV is greater than or equal to zero, accept the investment; otherwise, reject the investment.

If the NPV is greater than zero, the rate of return from the investment is higher than the required rate of return.

If the NPV is zero, the rate of return from the investment equals the required rate of return.

If the NPV is less than zero, the rate of return from the investment is less than the required rate of return.

## Capital Budgeting with the Internal Rate of Return

The internal rate of return (IRR) is the rate required (r) to get an NPV of zero for a series of cash flows.

The IRR represents the time-adjusted rate of return for the investment being considered.

The IRR decision rule states that if the IRR is greater than or equal to the company’s required rate of return (recall that this is often called the hurdle rate), the investment is accepted; otherwise, the investment is rejected.

Most managers use a spreadsheet, such as Excel, to calculate the IRR for an investment (we discuss this later in the chapter). However, we can also use trial and error to approximate the IRR.

The goal is simply to find the rate that generates an NPV of zero.

Although it is useful to know that the investment’s return is greater than the company’s required rate of return, managers often want to know the exact return generated by the investment.

(It is often not enough to state that the exact return is something higher than 10 percent!)

Managers also like to rank investment opportunities by the return each investment is expected to generate.

Our goal now is to determine the exact return—that is, to determine the IRR.

We know from that the copy machine investment generates a return greater than 10 percent. summarizes this calculation with the 2 columns under the 10 percent heading.

The far right side of shows that the NPV is \$(2,100) if the rate is increased to 12 percent (recall our goal is to find the rate that yields an NPV of 0).

Thus the IRR is between 10 and 12 percent. Next, we try 11 percent. As shown in the middle of , 11 percent provides an NPV of \$(469).

Thus the IRR is between 10 and 11 percent; it is closer to 11 percent because \$(469) is closer to 0 than \$1,250. (Note that as the rate increases, the NPV decreases, and as the rate decreases, the NPV increases.)

Note: the NPV of \$(469) is closest to 0. Thus the IRR is close to 11 percent.

This trial and error approach allows us to approximate the IRR.

As stated earlier, if the IRR is greater than or equal to the company’s required rate of return, the investment is accepted; otherwise, the investment is rejected.

For the company, the IRR of approximately 11 percent is greater than the company’s required rate of return of 10 percent. Thus the investment should be accepted.

## Capital Budgeting with Throughput Analysis

Throughput is measured as the amount of material passing through a system. Throughput analysis is the most complex capital budgeting analysis type, but is also the most precise in assisting managers decide which projects to embark on. Under this method, the whole company is a single system which generates profit. The analysis assumes that almost every cost in the system is operating expenses, that in order for the company to pay for expenses it has to maximize the entire systems throughput, and that maximizing profits involves maximizing the throughput passing through a bottleneck operation. A bottleneck is the systems resource which needs the longest time in operations. This implies that managers should give more preference to capital budgeting projects which affect and increase throughput passing through the bottleneck.

## Capital Budgeting Using DCF Analysis

DCF analysis is synonymous to or the same as NPV analysis in that it examines the first cash outflow required to fund a project, the combination of cash inflows assuming revenue forms, and other future outflows assuming maintenance and other cost forms. These costs, save for the first outflow, are discounted back to the current date. The NPV is the resulting number of the DCF analysis. Projects having the highest NPV should rank over other projects except in situations where one or more are mutually exclusive.

## Capital Budgeting with the Payback Method

Although the net present value (NPV) and internal rate of return (IRR) methods are the most commonly used approaches to evaluating investments, some managers also use the payback method.

The payback method evaluates how long it will take to “pay back” or recover the initial investment.

The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflows for the investment.

Managers who are concerned about cash flow want to know how long it will take to recover the initial investment. The payback method provides this information.

Managers may also require a payback period equal to or less than some specified time period, regardless of the NPV or IRR.

Note that the payback method has two significant weaknesses.

First, it does not consider the time value of money.

Second, it only considers the cash inflows until the investment cash outflows are recovered; cash inflows after the payback period are not part of the analysis.

Both of these weaknesses require that managers use care when applying the payback method.

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