Chapter 4: Capital Budgeting

Introduction

Capital budgeting includes long-term decisions about noncurrent assets of a company. The outcome of capital budgeting is either approval or rejection of the investment project.

In order to position the capital budgeting in business finance, it is essential to identify the relationships between capital budgeting, cost of capital, and capital structure. One of the most important factors is the cost of capital because it determines how capital investment projects will be financed, and how capital structure will be changed. Both overinvestment and underinvestment cost a company a lot of money because of the inefficient use of a company’s scarce resources and they both hamper managers’ efforts to create shareholder value.

Key Concepts in Capital Budgeting

Investment consists all kinds of spendings made for acquiring, sustaining, and increasing production factors.
Capital expenditure is the outlay of funds by the firm that is expected to produce benefits over a period of time longer than one year.

Capital budgeting is the process of evaluating and selecting long term investments which are consistent with the firm’s main objective of maximizing shareholders’ wealth.

Megginson et al. (2010) briefly explain the process of capital budgeting in three basic steps:

1. Identifying potential investments
2. Analyzing the set of investment opportunities, isolating those that will create shareholder value, and prioritizing them if necessary
3. Implementing and monitoring the investment projects selected

Classifying Capital Investment Projects

We can classify capital investment projects based on motivations to make the investment, and based on relative state of the investments regarding dependence on each other. Generally, reasons to make a capital investment project fall in one of the following groups:

1. Replacement of the existing plant and equipment

2. Modernization of the existing plant and equipment

3. Expansion of the existing and new products

Relative state of the investments regarding dependence on each other may be one of the following: Mutually exclusive projects, independent projects, contingent projects.

Corporate Strategy and Capital Budgeting

Corporate strategy includes both strategies for company’s whole portfolio of resources and strategies for only business unit’s products.

For capital budgeting matters, the aim of corporate strategy is to find investment projects which provide positive net present value for the company. In perfectly competitive markets it is assumed that it is not possible to find investment projects which provide positive net present value. The higher the competition levels in the market, the more difficult the profitable investment projects to find.

Competitive advantage , “a firm’s attribute that may allow the firm to generate economic profits” is key here. Here, economic profit refers to the risk-adjusted present value of revenue minus all costs, including the opportunity cost of capital.

Positive economic profits (or positive net present value projects) can stem from two sources: i) market imperfections, ii) creating competitive advantage.

Estimating Project Cash Flows

Accuracy of the cash flow estimation directly determines the decision about a project because the analyses depend on cash flows after taxes, rather than accounting profit (or net income).

Financial managers develop cash flow forecasts by using the input data coming from other departments such as engineering, manufacturing, marketing, accounting, etc. Only information which is relevant to the project’s analysis is used in developing forecasts. This is called incremental cash flow , a change in a firm’s net cash flow attributable to an investment project.

Sunk cost refers to a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.

Opportunity cost refers to the return on the best alternative use of an asset; the highest return that will not be earned if funds are invested in a particular project.

Externalities refer to the way in which accepting a project affects the cash flows in other areas of the firm.

There are two very important items that are related to the estimation of investment projects’ cash flows: financing costs and depreciation.

Financing costs are incorporated in the capital budgeting analysis with the determination of discount rate, rather than with the estimation of cash flows.

A project’s cash flow = Net income of project + Depreciation

Capital Budgeting Evaluation Techniques

The second step in the capital budgeting process is analyzing the set of investment opportunities, isolating those that will create shareholder value, and prioritizing them if necessary. Techniques explained in this section assume that all investment projects the same level of risk.

Payback Period

Payback period tells the length of time it takes to get initial cash outflow back, that is the period from the initial cash outflow to the time when the investment project’s cash inflows add up to the initial cash outflow. Risk is not inherited in the calculation of payback period. Moreover, this technique does not account for the time value of money.

Besides its easiness, payback period technique has important drawbacks. since it provides a big cash inflow after the cutoff point in time, a manager would miss it. Besides this drawback, payback period technique is criticized because it does not account for the time value of money and for the risk differences among projects.

Discounted Payback Period

Same as payback period, discounted payback tells the length of time it takes to get the initial cash outflow back, that is the period from the initial cash outflow to the time when the investment project’s cash inflows add up to the initial cash outflow. Projected cash flows are discounted at an appropriate discount rate and their present values are used to calculate payback period.

This technique assumes that cash flow occurs at a constant rate throughout the year, and assumes that all investment projects have the same level of risk.

If a project is independent approve the project(s) that pays the initial investment back less than a specified payback period.

Net Present Value (NPV)

Net present value of a project is the sum of present value of all cash inflaws and cash outflows of a project over its life. If the NPV is greater than zero (positive NPV) for a project, it means that the project will increase the shareholder value by that amount. If the NPV is smaller than zero (negative NPV) for a project, it means that the project will decrease the shareholder value by that amount. There are three steps of calculating NPV:

1. Estimating cash flows
2. Discounting cash flows by an appropriate discount rate
3. Adding up the discounted cash flows to obtain NPV

One should use a higher discount rate for finding the NPV of riskier projects and reflect the extra amount of return demanded by investors in order to compensate for the risk. That is because the riskier the project, the higher the expected rate of return.

For independent projects, approve projects with positive NPV. Reject projects with negative NPV. For mutually exclusive projects, choose the project with the biggest NPV.

Internal Rate of Return (IRR)

Internal rate of return is the rate of return that causes the net the present value of a project to be zero.

Internal rate of return technique assumes that all investment projects have the same level of risk.

If a project is independent, approve the project(s) that provides IRR that is greater than the expected rate of return (discount rate used in NPV technique). If a project is mutually exclusive, choose the project that provides the highest IRR (that is greater than the expected rate of return (discount rate used in NPV technique)).

Modified Internal Rate of Return

Modified internal rate of return technique assumes that all investment projects have the same level of risk. The decision rule is similar to IRR. If a project is independent, approve the project(s) that provides MIRR that is greater than the minimum rate of return (discount rate used in NPV technique). If a project is mutually exclusive, choose the project that provides the highest MIRR (that is greater than the minimum rate of return (discount rate used in NPV technique)).

Modified internal rate of return technique finds the rate of return that equates the future value of all cash outflows with the sum of the future value of all cash inflows as of the end of the project’s life.

Terminal value refers to the sum of the future value of all cash inflows as of the end of the project’s life.

Profitability Index (PI)

Profitability index is the ratio between the present value of all cash inflows and the present value of all cash outflows. This ratio is also project’s benefit/cost ratio. It tells the ratio of the present value of a project’s cash inflows to the present value of all cash outflows or initial cash outflow.

If a project is independent, approve the project(s) that provides profitability index greater than 1. If a project is mutually exclusive, choose the project that provides the biggest profitability index (which is also greater than 1).

Incorporating Risk in Capital Budgeting

There are three kinds of risk sources when we talk about the risk of an investment project: Stand-alone risks, within-firm risks, market risks .

One can account for risk differences among alternative investment projects by making adjustments to either cash flows or the discount rate.

Certainty-equivalent coefficient refers to a number between 0 and 1 which is used in order to reflect the risk of a project to evaluation.

In adjusted cash flow approach , one should use risk-free interest rate as a discount rate while calculating net present value because risk of a project is already included in cash flow adjustment.

If a project’s risk is substantially above the firm’s general risk, discount rate will be above the WACC. If a project’s risk is substantially below the firm’s general risk, discount rate will be below the WACC.

For a given capital investment project, it would be appropriate to expect that a manager who is risk-averse adds a greater risk premium to discount rate than a manager who is risk-seeking.

Sensitivity, Scenario and Simulation Analysis

Sensitivity, scenario, and simulation analysis are approaches which seek answers to “what if” kind of questions to capital investment projects.

Sensitivity analysis is the analysis of the effects on project profitability of changes in sales, costs, and so on. Scenario analysis is the analysis given in given a particular combination of assumptions. Simulation analysis is an extention of scenario analysis which includes the estimation of the probabilities of different possible outcomes from an investment project.

Decision Tree Analysis

Decision trees are tools to associate probabilities to each possible outcome for an event and map out the possible outcomes and the value of the investment opportunity associated with these different outcomes.

Real Options Approach in Project Analysis

Real options approach is getting more attention from managers as it allows them to include uncertainty and other strategic quantitative factors to their valuation of an investment project.

Real options refer to the options of managers about capital investment projects which can be priced by using stock option-pricing methodologies.

Real options are priced in a similar way like stock options which is called real option valuation (ROV).

If projects are independent, positive net present value projects will be approved, but negative net present value projects will be rejected. If projects are mutually exclusive, the project providing the biggest NPV will be preferred.