FAQ: Capital Budgeting and Investment

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Dominic Banks
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1 Question 1: What are the strengths and weaknesses of the payback period method? Answer 1: The payback period method is a capital budgeting tool that is used to calculate the amount of time (usually in terms of years) required to recoup an investment using estimated future cash flows. The payback period method, although considered a crude methodology by some in the financial community as compared to other methods available, was the first formal financial method employed by firms to evaluate capital budgeting projects. The actual calculation method uses the future cash flows to offset the initial investment until a partial year is reached, then the balance of the investment is divided by the cash flow for that period. The most significant disadvantage that the payback period method has is that it does not incorporate the concept of discounted cash flows; however, there have been variants developed, such as the discounted payback period method, that do take the concept of discounting cash flows into account. The most significant strength that the payback period has to offer is its simplicity. Virtually any manager can use the payback period for at least a rough estimate of what period of time will be required for the firm to recoup its investment based on the estimates of the future cash flows. Question 2: Why is capital budgeting important to a company? Answer 2: There are several reasons why the capital budgeting process is important to companies. The capital budgeting process allows a company to analyze projects so that it is able to decide where to allocate its scarce resources. It also helps identify the better project to undertake when two projects are mutually exclusive, meaning that there is a decision to be made because both projects cannot be completed at the same time. The capital budgeting process is also important because of the duration of impact the projects carry on a company. Capital projects in most instances impact a company for several years, so incorrect decisions can be a long-lived problem. Also, if a company overinvests, it faces the problem of costs that may affect the company's ability to react and respond to other opportunities and issues that arise. The capital budgeting process is also critical from the perspective of timing. For a company to have the necessary resources (cash or credit) available, it must know what to expect in terms of capital requirements and future cash flows. 1

2 Question 3: What are the six steps used in capital budgeting? Answer 3: Although there obviously can be variations to the process depending on the need of the particular project, there are six common steps used in the capital budgeting process (Brigham & Gapenski, 1994): 1. Determining the cost of the project being analyzed 2. Estimating the expected cash flows from the project, including the terminal value of the capital equipment at the end of its life (positive or negative) 3. This step involves assessing or estimating the risk level of the estimated cash flows from the project. A probability distribution can be incorporated into the analysis depending on the method being used in the analysis. 4. This step is determining the cost of capital to be used in the analysis for the purpose of discounting the cash flows. The cost of capital estimate will need to consider the level of risk assigned to the project and its cash flows. 5. Bringing the expected future cash flows back to a present value basis 6. Using the present value of the future cash flows for the project to compare to the investment of the project to see if the return is acceptable These steps are the financial aspect of the decision process. From this point, management needs to take in any other considerations prior to a final decision. Question 4: What are the motivations for capital investment? Answer 4: The motivations for a company to make a capital investment generally can be classified into one of six categories (Brigham & Gapenski, 1994): The first motivation, replacement, centers on the company replacing worn out or damaged equipment (maintenance of business). The major decision to be made in this instance is whether the product should be continued and whether the same facility and equipment should be used. The second motivation is replacement for the purpose of cost reduction. As these decisions are more discretionary, the evaluation assesses if the extra investment is warranted, especially if the capital 2

3 could be used more effectively elsewhere. The third motivation is expansion of current products and/or markets. These decisions can be more problematic because there is an extensive reliance on the accuracy of the estimated cash flows. The fourth motivation is expansion of new products and/or markets. Along with the financial calculations and evaluations at hand, the company strategy needs to be considered. It will need to be determined if the investment looks to satisfy the company's strategic needs and objectives. The fifth motivation is safety or environmental projects. Safety or environmental projects can be required for many reasons, including adherence to federal, state, and local laws and regulations. The projects are often referred to as mandatory investments or nonrevenue-producing projects. The final motivation category is essentially a catch all. It may include almost anything not captured in the previous categories, and may include investments such as such as parking lots, executive aircrafts, and so forth. Question 5: What is the net present value (NPV) method? Answer 5: The NPV method of capital budget relies on the concept of discounted cash flows. When a company is evaluating a capital budgeting decision, the discounted cash flow concepts allow a company to calculate the value of the estimated future cash flows in terms of today's dollar value (to offset the impact of inflate on those future cash flows). The process for calculating the NPV for a project is to complete those calculations that put the value of the future cash flows (for the identified term of the project and to include the original investment and the terminal or salvage value of the project at the end of its life) on a current value basis. To complete the NPV calculation, the company has to assume a cost of capital, which is the interest rate that the firm will experience for the project. The decision criteria are that if the NPV of the project s cash flow is positive, then the project can be accepted. What the NPV methodology allows a company to do is evaluate if the project s return is a positive, neutral, or negative investment against a set rate for the cost of capital. When two projects are mutually exclusive, the NPV methodology can be relatively easy to incorporate and use. 3

4 Question 6: What is the internal rate of return (IRR) method? Answer 6: The IRR methodology is also based on the concept of discounted cash flows. The concept of discounting the future cash flows of a project allows a company to evaluate a capital budgeting decision in terms of today's dollar value, and it eliminates the impact of inflation on the capital budgeting decision. The IRR methodology method differs from the NPV methodology because the IRR method seeks to calculate the exact cost of capital for a company, as opposed to calculating a positive, neutral, or negative value as decision criteria. As the IRR method provides the company the exact rate of return (or cost of capital) for the future cash flows of the project, it can allow the company a closer measurement for deciding between two or more proposed capital projects. The purpose of the IRR calculation is to find the point where the NPV uses a discount rate (cost of capital) to calculate NPV to be zero. The IRR method is very similar to the NPV methodology in assessing present value, but due to the need to find the discount rate where the NPV is zero, the calculations are inherently more complex. An iteration process must be used to complete the IRR calculation, and that process is best accomplished using financial software or a modern financial calculator. Question 7: When is the modified rate of return (MIRR) method used? Answer 7: MIRR methodology is an improvement to the IRR methodology because it helps the decision makers in the capital budgeting process make their decisions through framing the calculation into a better indicator of relative profitability (Brigham & Gapenski, 1994). Despite academia's preference of the NPV methodology, most managers prefer the IRR over NPV by more than a three to one margin (Brigham & Gapenski, 1994). The MIRR methodology finds a balance for managers between the benefits of both NPV and IRR methodologies. What the MIRR methodology does is incorporate changes to the IRR methodology, and as a result, it enjoys several significant advantages over the IRR methodology. The most important improvement is that the MIRR methodology assumes that the cash flows from each project are reinvested at the cost of capital, or its own cost of capital or IRR (Brigham & Gapenski, 1994). The concept is that because the reinvestment of the cash flows is based on the project s own IRR or cost of capital, the rate is generally more correct, which provides a better indicator of the project's profitability. The 4

5 MIRR methodology also solves a problem experienced with the IRR methodology referred to as the multiple IRR problem (Brigham & Gapenski, 1994). Question 8: How does life cycle cost analysis (LCCA) interface with capital budgeting? Answer 8: The LCCA is used to estimate all of the costs that will be incurred throughout the ownership life of a project or a system. Although there are several LCCA models from which to select, depending on the type of project being evaluated and the particular constraints of each capital budgeting project, all of the models are designed to help a company identify and categorize the types of costs required in each stage or phase of the project. To correctly assess the current value of the cost of ownership of a capital budgeting project, a company must not only have a firm grasp of the estimation of the future cash flows of a project, it must have an equally good grasp of the offsetting costs of the project. Miscalculation from either the cash outflows or the cash inflows will cause the current value of the project to be misrepresented and the results can be catastrophic for a company. Question 9: What are mutually exclusive capital projects? Answer 9: Companies constantly try to manage their scarce resources in the most effective and efficient manner possible. Most companies cannot undertake every capital budgeting project that is identified and that meets the financial criteria set by the company. Likewise, two mutually exclusive projects cannot be chosen, even if they both have a positive NPV. Mutually exclusive projects are the projects that cannot be chosen at the same time because they would accomplish the same purpose (redundancy) or one of the projects would require resources that the other project would also need. Question 10: Why are capital budgeting postaudits important? Answer 10: The adoption of postaudits can assist a company in completing a forensic analysis of its capital budgeting decisions. Because most capital budgeting decisions for a company occur on critical projects or involve significant amounts of the company's capital (cash), obtaining quick feedback about the performance of those investments can be important feedback for a company. 5

6 Through conducting postaudits, companies can identify where the costs of a project stand compared to the projected cash flows used in the capital budgeting decisions. As these shortfalls or overages are identified, countermeasures can be put into place in the LCCA(s) used to estimate the negative cash flows of the project, and improvements can be implemented to improve the estimation of the positive future cash flows of the capital project. Through a solid postaudit system for the capital budgeting process, companies can incorporate a continuous improvement methodology into the process and build confidence into that system. Reference Brigham, E. F., & Gapenski, L. C. (1994). Financial management: Theory and practice (7th ed.). Orlando, FL: The Dryden Press. 6

CHAPTER 2 LITERATURE REVIEW

CHAPTER 2 LITERATURE REVIEW Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept. (Pearson Education, 2007, 178). 2.1. INTRODUCTION OF CAPITAL BUDGETING