ISBN: 0-03-028931-9

Chapter 11 The Basics of Capital Budgeting

Capital budgeting is the process of analyzing potential fixed asset investments. Capital budgeting decisions are probably the most important ones financial managers must make. Its importance is particularly important because the firm loses much of its flexibility by locking into projects, because asset expansion is based upon expected future sales, and because capital budgeting decisions define the firm's strategic direction. Effective capital budgeting can improve both the timing and the quality of asset acquisitions.

If a firm overestimates its asset requirements, it will incur unnecessarily high depreciation expenses, as well as other expenses. If a firm underestimates its asset requirements, it may find its existing assets are not sufficiently modern to enable it to produce competitively and it may loose market share to rival firms if it has inadequate capacity.

Generally speaking, capital budgeting projects can usually be classified into one of the following categories: (1) replacement of existing equipment for maintenance purposes, (2) replacement for the purpose of cost reduction, (3) expansion of existing products or markets, (4) expansion into new products or markets, and (5) safety and/or environmental projects.

Capital budgeting and security valuation are similar in each of the following respects: (1) The cost of the project must be determined (like finding the price of a bond or stock), (2) the expected cash flows of the project, both operating and terminal, must be determined (like identifying dividends and coupon payments), (3) the riskiness of project cash flows must be estimated, (4) the cost of capital for the project must be determined, (5) expected cash flows are put into present value terms (like finding the value of a stock or bond), and (6) the present value of the expected cash flows is compared to the cost. If the present value of cash flows is greater than the cost, the project is accepted.

A normal cash flow stream is one where there is a single or series of costs (or cashflows, alternatively) followed by a single or series of cashflows (or costs). Where costs are negative dollar values and cash flows are positive, there is only one sign change. A nonnormal cash flow stream is one in which there are multiple sign changes.

A sample of projects are said to be independent if the project's cash flows are not affected in any way by the acceptance or nonacceptance of other projects. Projects are said to be mutually exclusive if the acceptance of one project has any consequence upon the decision of another project. The latter case is the most often seen, as firms must efficiently allocate resources amongst a host of investment opportunities.

The payback period is defined as the number of years required to recover a project's 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 invested capital will be "at risk."

The discounted payback method is similar to the 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.

The net present value (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.

An NPV profile is a graph of the net present value with the cost of capital as the dependent variable. The x-intercept of such a graph represents the cost of capital at which a project has a NPV of zero, the IRR. If two projects are graphed, they will likely intersect each other somewhere in the first quadrant. The point of intersection is called the crossover point. The crossover point tells you at which cost of capital these projects have the same NPV, and what that NPV is. The crossover can be determined by finding the annual difference of cash flows and finding the IRR of that stream.

The NPV and IRR methods make the same accept/reject decisions for independent projects, but if projects are mutually exclusive, then ranking conflicts can arise. If conflicts arise, the NPV method should be used. The NPV and IRR methods are both superior to the payback, but NPV is superior to IRR. At a cost of capital greater than the crossover, the NPV and IRR methods will yield the same results. Below the crossover, the NPV and IRR will give conflicting results.

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 IRR (MIRR) method corrects some of the problems with the regular IRR. MIRR involves finding the terminal value (TV) of the cash inflows, compounded at the firm's cost of capital, and then determining the discount rate which forces the present value of the TV to equal the present value of the outflows. The MIRR method also eliminates the multiple IRR problem.

Sophisticated managers consider all of the project evaluation measures because each measure provides a useful piece of information.

The 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, or (3) the small-business owner may be considering nonmonetary goals.

Although this chapter has presented the basic elements of the capital budgeting process, there are many other aspects of this crucial topic. Some of the more important ones are discussed in the following chapter.

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