The capital budgeting process involves project generation, process evaluation, project selection, and project execution. These steps are necessary but more may be added to make the process more effective. It can be well appreciated that the capital budgeting process is one of the most significant decision areas. The initial expenditures involved are very large, affecting the company’s operations on a long-term basis, and are generally irreversible (Brigham and Houston 2008, 11). Therefore, capital expenditure decisions are more delicate and a reserve for the top management.
Most healthy companies face a continuous flow of profitable investment proposals, which have to be assessed to select the best possible proposal. Project evaluation involves two steps. The first step is the estimation of benefits and costs in terms of cash flows. The estimation of cash flows is a difficult task since the future is uncertain (Brigham and Ehrhardt 2010, 37). The risks related to the projects should be well taken care of and considered in the assessment process. The second step involves the selection of an appropriate criterion that will be used to judge the desirability of the project. Project selection includes screening and selection procedures used to approve an investment proposal while project execution involves an implementation process that follows the final selection of investment proposals.
Because of the importance and implications of the capital budgeting decision, a reliable appraisal method should be adopted to ascertain the monetary value of each investment proposal. An appropriate investment evaluation criterion should be able to provide a means of distinguishing between acceptable and unacceptable projects. The criterion should provide a basis for ranking projects in terms of their desirability, therefore solving the problem of having to choose among alternative projects. The criterion should also be applicable for a wide range of investment proposals. There are several investment criteria, commonly grouped into two criteria. The payback period is a “conventional criterion, while the NPV and IRR are discounted cashflow criteria.”
The net present value (NPV) method is a classic economic method of evaluating investment proposals and is one of the discounted cash flow techniques that explicitly recognize the time value of money (McMenamin 1999, 73). It acceptably assumes that cashflows earned at various periods vary in worth and are only realized when their equivalent and PVs are calculated. Cash flows in the future are discounted using the company’s cost of capital as the discounting rate while cash flows made in the present remain the same (Vance 2002, 57).
The net present value (NPV) is arrived at by deducting the PV of current values of cash-outflows from the PV of future cash inflows. Therefore, the NPV calculates the PV of cash flows of an investment proposal, using the cost of capital as the appropriate discounting rate, and determines the PV of the investment proposal by subtracting the PV of cash-outflows from the PV of cash inflows. The depreciation is added back to the net profit figure to result in cash profit. The depreciation charges for each project are found by dividing the cost minus the residual value by the number of years.
Net present value
|Year||Cash inflows||Discounting factor at 10%||PV of cash inflows|
|Project 1||Project 2||Project 1||Project 2|
|Less investment outlay||100,000||60,000|
The most significant advantage of the NPV method is that it recognizes the time value of money, and considers all cash flows over the entire life of the project in its calculations. As a rule of thumb for using the net present value method, an investment proposal should only be considered only if its net present value is positive; this implies that the present value of cash-inflows exceeds or equals the present value of cash outflows. An investment that results in an NPV of zero should not be undertaken, since the firm would be indifferent at the end of the project. From the calculations above, both projects have positive net present values, though project 1 is recommended since it has a higher NPV (Shim and Siegel 2008, 79).
Another discounted cash flow technique is the internal rate of return (IRR); considers the amount and timeliness of cashflows. The IRR method is also referred to as yield to investment, the marginal efficiency of capital, rate of return over cost or time alternatively the time-adjusted rate of return (Pike and Neale 2006, 102). The IRR can be defined as the discounting rate which compares the PV of cash inflows to the PV of cash-outflows of an investment project, that is, it is the rate at which the NPV of the project is zero. It is also known as the internal rate since it relies more on the capital investment and returns expected from the proposal, unlike other rates established from outside the project.
The IRR equation uses the same calculations used for the NPV method with the major difference being in the required rate of interest or cost of capital. The net present value approach assumes that the cost of capital (k) is known, and uses the rate as the discounting factor to establish the net present value. Under the internal rate of return, the value of r has to be determined at the level where the net present value is zero, usually found out by employing trial and error. The approach is to select any rate of interest to compute the present value of cash flows. (Pike and Neale 2006, 96) notes “If the calculated present value of the expected cash inflows is lower than the present value of cash outflows, a lower rate should be tried. And the process is repeated until the net present value becomes zero.”
|Year||Cash inflow||r= 16%||PV||r = 17%||PV||r =16.5%||PV|
|Less cash outlay||100,000||100,000||100,000|
|year||Cash inflow||R = 16%||PV||R = 17%||PV||R= 16.5%||PV|
|Less cash outlay||60,000||60,000||60,000|
The accept or reject the rule, using the IRR method, is used to accept the project if its internal rate of return is higher than or equal to the minimum required rate of return, which is also known as the firm’s cost of capital, cutoff, or hurdle rate. The project is rejected if the firm’s cost of capital is lower than the cost of capital, in this case, 10 percent. The rationale behind this is that if a firm can borrow at a rate lower than the internal rate of return, the project would be profitable, while losses would be incurred by investing in the project whose borrowing rate is higher than the internal rate of return. From the above, both projects are feasible since they both have internal rates of return higher than ZYZ Ltd’s cost of capital. Project 2 is recommended since it has a higher internal rate of return as explained by the fact that project 1’s IRR is less than 16.5% while project 2’s IRR is higher than 16.5%.
Another appraisal method is the payback or payout period method. This is one of the commonly used conventional techniques of appraising investment proposals. The payback period is defined as the period in years needed to recoup the initial capital outlay inputted in a proposal. If it is expected that the investment earns steady yearly cash-inflows, the payback period can be measured by dividing cash-outlays by the yearly cash-inflows. However, when there are uneven cash-inflows, as is the case with the current example, the payback period can be measured by adding together the cash-inflows until the sum equals the original capital input.
Project 1 payback period = 60,000 + 30,000 + 34,000 = 3 years
Project 2 payback period = 36,000 + 16,000 + 22,000 = 3 years
The payback period can be used as an accept-or-reject criterion, as well as a basis for ranking projects. When the payback period calculated for a project is lesser than the longest payback period established then the firm should consider or accept such a project. From the above analysis, the payback period in each case is 3 years because the initial cash outlay is recovered by the end of the third year. Both projects are acceptable since the “standard payback period in each case is higher than the actual payback periods” (Gill and Chatton 2000, 60).
The payback period is the simplest to understand and calculate, and thereby inexpensive as compared to other complicated techniques, which consume much time and expertise. The method, however, suffers a lot of drawbacks due to its simplicity. Foremost, it does not consider the cash-inflows generated after the pay-back period, for example, project 1 and project 2 are considered at par since they both have the same payback period as of the foreseen future, but after that it is impossible.
In addition, the payback period does not offer a method of calculating the profitability of the project, and also does not take into account the pattern of cash-inflows in terms of magnitude and timing, that is, the method only gives equal weight to returns of equal values although they could be earned in various periods. “The payback period method is also not consistent to maximize company value since it does not analyze an investment project’s return.” (Pike and Neale 2006, 56)
The net present value interpretations are easily understandable, where the positive NPV would be regarded as an immediate increase in the company’s wealth if the firm decides to go ahead with the investment proposal. The most significant value of the NPV method is that it recognizes the time value of money, as opposed to the payback method, and considers all cash flows over the entire life of the project. The internal rate of return may be interpreted as the highest rate of interest a company would be willing to service interests emanating from the borrowings used to finance the project, without being worse off while repaying the loan inclusive of interest charges. Like NPV, IRR takes into account the time value of money, but the major difference is that NPV presupposes the cost of capital while IRR does not (Bragg 2006, 151).
Both IRR and NPV are compatible with the firm’s objective of increasing shareholder value and are thus more superior to the payback method. NPV criterion is simpler to operate than the IRR method; however, the latter suffers from the limitation of multiple rates. The NPV method is consistent with giving reliable solutions to the problems of investment analysis and is, therefore, more realistic than the IRR method.
However, the IRR method is more appealing than the NPV because it is more meaningful in terms of measuring profitability and risk while taking the time and quantity of investment into consideration. In the illustration, the solutions offered by NPV and IRR differ because project 1 involves a significantly larger investment than project 2, thereby resulting in a higher NPV. The IRR recommends that project 2 be more favorable since it has the best yield, and uses less investment. The IRR, therefore, has the advantage of offering investors the maximum rate of return.
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Brigham, E. F. and Ehrhardt, M. C., 2010. Financial Management: Theory and Practice, 13th ed. New York: Cengage Learning.
Brigham, E. F., and Houston, J. F., 2008. Fundamentals of financial management, 6th ed. New York: Cengage Learning.
Gill, J. O. and Chatton, M., 2000. Financial analysis: the next step, 2nd ed. New York: Crisp Publications.
McMenamin, J., 1999. Financial management: an introduction. New York: Routledge.
Pike, R. and Neale, B., 2006. Corporate finance and investment: decisions & strategies, 5th ed. New York: Financial Times Prentice Hall.
Shim, J. K. and Siegel, J. G., 2008. Financial Management, 3rd ed. Hauppauge, NY: Barron’s Educational Series.
Vance, D. E., 2002. Financial analysis and decision making: tools and techniques to solve financial problems and make effective business decisions. New York: McGraw-Hill Professional.