Capital Budgeting

CAPITAL BUDGETING

This topic will discuss the capital budgeting process. One of the key concepts that will be covered are listed below.

                Capital budgeting.

This the process of analyzing potential fixed asset investments. Capital budgeting decisions are probably the most important ones financial managers must make.

The pay back period.

            This period is defined as the number of years required to recover a projects cost. The regular payback method ignores cash flows beyond the payback period, and it does not consider the time value of money. The payback does, however, provide an indication of a project’s risk and liquidity, because it shows how long the invest capital will be at risk.

The discounted payback method.

            This method is similar to regular payback method except that it discounts cash flows at the project’s cost of capital. It considers the time value of money, but it ignores cash flows beyond the payback period.

Net Present Value method.

            The NPV method discounts all cash flows at the project’s cost of capital and then sums those cash flows. The project is accepted if the NPV is positive.

The internal rate of return.

            IRR is defined as the discount rate which forces a project’s NPV to equal zero. The project is accepted if the IRR is greater than the cost of capital.

            The NPV and IRR methods make the same accept and reject decisions for independent projects, but if projects are mutually exclusive, then ranking conflicts can rise. If conflicts arise, NPV method should be used. The NPV and IRR methods are both superior to the payback, but NPV is superior to IRR.

            The NPV method assumes that cash flows will be reinvested at the firm’s cost of capital, while the IRR method assumes reinvestment at the project’s IRR. Reinvestment at the cost of capital is generally a better assumption in that it is closer to reality.

The Modified internal rate of return.

            The MIRR method corrects some of the problems with the regular IRR. MIRR involves finding the terminal value (TV) of the cash in-flows, compounded at the firm’s cost of capital, and then determining the discount rate which forces the present value of the terminal value to equal the present value of the outflows.

Post audit.

            Post audit is a key element of capital budgeting. By comparing actual results with predicted results and then determining why differences occurred, decision makers can improve both their operations and their forecasts of projects outcomes.

            Small firms tend to use the payback method rather than a discounted cash flow method. This may be rational, because

1.      The cost of conducting a DCF analysis may outweigh the benefits for the project being considered,

2.      The firm’s cost of capital cannot be estimated accurately

3.      The small business owner may be considered non-monetary goals.

Investment decisions involving fixed assets known as capital budgeting. Here the term capital refers to long term assets used in production, while a budget is a plan which details projected inflows and outflows during some future period. Thus, the capital budget is an outline of planned investments in fixed assets and capital budgeting is the whole process of analyzing projects and deciding which ones to include in the capital budget or the process of planning expenditures on assets whose cash flows are expected to extend beyond one year.

Importance of Capital Budgeting.

Following factors combine to make capital budgeting perhaps the most important function financial managers and their staffs must perform.

1.      A firm’s capital budgeting decisions define its strategic direction, because moves into new products, services or markets must be proceeded by capital expenditures.

2.      Capital budgeting also help a firm in the case of the purchase of an asset with an economic life.  That is an asset a decision to buy an asset that is expected to last 10 years requires a ten year sales forecast.

3.      Capital budgeting helps a firm to forecast correctly in case of assets. That is it helps a firm to know that if it invest too much, it will incur unnecessarily high depreciation and other expenses. On the other hand, if it does not invest enough, two problems may arise. First, its equipment may not be sufficiently modern to enable it to produce competitively. Second, if it has inadequate capacity, it may lose market share to rival firms and regaining lost customers requires heavy selling expenses, price reductions all of which are costly.

4.      Time being important, capital budgeting help businesses to make sure that capital assets are available when they are needed.

5.      Effective capital budgeting can improve both the timing and the quality ofasset acquisitions. If a firm forecasts its needs for capital assets in advance, it can purchase and install the assets they are needed.

6.      The amount of cash involved in a fixed asset investment may be so large that it could lead to the bankruptcy of a firm if the investment fails. Consequently, capital budgeting is a mandatory activity for larger fixed asset proposals.

Generating Ideas for Capital Projects.

      Capital budgeting projects are created by the firm. For example, a sales representative may report that customers are asking for a particular product that the company does not now produce. The sales manager then discusses the idea with the marketing research group to determine the size of the market for the proposed product. If it appears that a significant market does exist, cost accountants and engineers will be asked to estimate production costs. If they conclude that the product can be produced and sold at a sufficient profit, the project will be undertaken.

      A firm’s growth and even its ability to remain competitive and to survive, depends on a constant flow of ideas for new products, for ways to make existing products better, and for ways to operate at a lower cost. Accordingly, a well managed firm will go to great lengths to develop good capital budgeting proposals.

Project Classification.

      Analyzing capital expenditure proposals is not a costless operation, benefits can be gained, but analysis does have a cost. The following are some ways for project classification.

1.      Replacement: Maintenance of Business. One category consists of expenditures to replace worn out or damaged equipment used in the production of profitable products. Replacement projects are necessary if the firm is to continue in business. The only issues here are:

a.      Should this operation be continued and

b.      Should we continue to use the same production processes?.

The answers are yes, so maintenance decisions are normally made without going through an elaborate decision process.

2.      Replacement: Cost Reduction. This category includes expenditures to replace serviceable but obsolete equipment. The purpose here is to lower the costs of labor, materials and other inputs such as electricity. These decisions are discretionary and a fairly detailed analysis is generally required.

3.      Expansion of existing products or markets. Expenditures to increase output of existing products or to expand retail outlets or distribution facilities in markets now being served are included here. These decisions are more complex because they require an explicit forecast of growth in demand.

4.      Expansion into new products or markets. These are investments to produce a new product or to expand into a geographic area not currently being served. These projects involve strategic decisions that could change the fundamental nature of the business, and they normally require the expenditure of large sums of money with delayed paybacks.

5.      Safety and or environmental projects. Expenditures necessary to comply with government orders, labor agreements or insurance policy terms fail into this category.

in general, relatively simple calculations and only a few supporting documents are required for replacement decisions, especially maintenance type investments in profitable plants. A more detailed analysis is required for cost reduction replacements, for expansion of existing product lines, and especially for investments in new products or areas.

CAPITAL BUDGETING DECISION RULES.

Five key methods are used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget.

1.       Payback

2.       Discounted payback

3.       Net present value

4.       Internal rate of return and

5.       Modified internal rate of return

Method ONE.

Payback Period defined as the expected number of years required to recover the original investment. This was the first formal method used to evaluate capital budgeting projects.

                The shorter the payback period, the better. .

Mutually exclusive projects.

                These are set of projects where only  one project can be accepted.  So this means that if one project is taken on, the other must be rejected. For example the installation of a conveyor belt system in a warehouse and the purchase of a fleet of forklifts for the same warehouse would be mutually exclusive projects.

Independent projects.

Independent projects are projects whose cash flows are independent of one another. That is projects whose cash flows are not affected by the acceptance or nonacceptance of other projects.

                Discounted Payback Period.

The length of time required for an investment’s cash flows, discounted at the investment’s cost of capital, to cover its cost that is this is the number of years required to recover the investment from discounted net cash flows.

                An important drawback of both the payback and discounted payback methods is that they ignore cash flows that are paid or received after the drawback period.

                Although the payback method has some serious faults as a ranking criterion, it does provide information on how long funds will be tied up in a project. Thus the shorter the payback period. Other things held constant, the greater the projects liquidity. Also since cash flows expected in the distant future are generally riskier than near term cash flows, the payback is often used as one indicator of a project’s riskiness.

Method TWO

Net Present Value(NPV)

                As the flaws in the payback were recognized, people began to search for ways to search for ways to improve the effectiveness of project evaluations. One such method is the net present value method which relies on discounted cash flow (DCF) techniques.

NPV method is a method of ranking investment proposals using the NPV, which is equal to the present value of future net cash flows, discounted at the marginal cost of capital.

DCF techniques are methods for ranking investment proposals that employ time value of money concepts.

To implement this approach, we proceed as follows:

1.       Find the present value of each cash flow, including both inflows and outflows, discounted at the project’s cost of capital.

2.       Sum these discounted cash flows, this sum is defined as the project’s NPV

3.       If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPV’s are mutually exclusive, the one with the higher NPV should be chosen.

Rationale for the NPV Method.

        The rational for the NPV method is straightforward. An NPV of zero signifies that the project’s cash flows are just sufficient to repay the invested capital and to provide the required rate of return on that capital. If a project has a positive NPV, then it is generating more cash than is needed to service its debt and to provide the required return to shareholders and this excess cash accrues solely to the firm’s stockholders. Therefore if a firm takes on a project with a positive NPV the position of the stockholders is improved.

Method THREE

Internal Rate of Return (IRR) Method

                A method of ranking investment proposals using the rate of return on an investment, calculated by finding the discount rate that equates the present value of future cash inflows to the project’s cost.

IRR, this is the discount rate which forces the Present value of a project’s inflows to equal the PV of its costs.

Rational for the IRR method.

            Why this particular discount rate that equates a project is’s cost with the present value of its receipts so special that is the IRR. The reason is based on this logic

a.      The IRR on a project is its expected rate of return

b.      If the internal rate of return exceeds the cost of the funds used to finance the project, a surplus remains after paying for the capital and this surplus accrues to the firm’s stockholders.

c.       Therefore, taking on a project who’s IRR exceeds its cost of capital increases shareholders wealth. On the other hand, if the internal rate of return is less than the cost of capital, then taking on the project imposes a cost on current stockholders. It is this breakeven characteristic that makes the IRR useful in evaluating capital projects.