Capital Budgeting Techniques and Project Analysis

At the end of this chapter, you will be able to:

 Explain the role of capital budgeting

 Describe the capital budgeting tools in financial management decision making

 Apply the various tools available to mitigate forecasting risk in project analysis and evaluation

Introduction

Budgeting is a financial plan to control both the operational and investment activities of an enterprise.
In Accounting for Decision Making course, the operational budget process that produces the pro-forma
financial statements has been discussed. Capital budgeting involves long-term decision-making
process affecting production capacity of the enterprise.

Capital budgeting is a process to evaluate long-term investment projects such as purchasing fixed
assets and advertising. Decisions made by the financial managers on the projects to be selected are
based on the company’s objectives. If the objective is to invest in a project with the shortest payback
period, then project with the shortest payback period will be selected. If the company’s objective is to
invest in a project with an acceptable rate of return, then project with the highest rate of return will be
ranked first.

Project with an acceptable rate of return will be chosen after considering other relevant factors such as
project period and so on. The decision on which projects to be selected also relates to future cash
flows, if a project is undertaken. There are four major stages in capital budgeting process:

1. Identify suitable projects

2. Calculating the cash flows

3. Evaluating and selecting projects

4. Implement and monitor the progress of the projects.

In deciding on whether to expand or contract the existing production facility, a decision needs to be
made between different choices such as to purchase, produce, or lease a new plant.

Projects that financial managers consider to invest can be categorized into two:

 Independent projects
Independent projects are projects selected based on the financial and other benefits that the
company would receive. The selection of one project does not effect the selection of other
projects. Projects selected may be none, a few or all of the choices. Capital budgeting
selection tools is further discussed in Capital Budgeting Tools & Criteria.

 Mutually exclusive projects

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 The project selected in this category is the one that best satisfies the objective of the firm.
Hence all choices will be evaluated before the selection. Capital budgeting selection tools is
further discussed in Capital Budgeting Tools & Criteria.

An independent capital budgeting decision would not consider an alternative choice but to evaluate
the economic viability of the projects or activities to be adopted. On contrary a mutually exclusive
capital budgeting decision takes into consideration alternate choices and evaluates comparative
economic advantage between the choices in order to arrive at a decision.

Capital Budgeting Tools

Capital budgeting techniques are developed to evaluate capital projects that involved long term cash
flows. Several capital budgeting tools have been developed to evaluate such cash flows in facilitating
the investment decision.

Capital budgeting is a long-term investment decision-making process that affects the production
capacity of the enterprise. With appropriate use of capital budgeting techniques, the manager should
be able to determine the financial viability of the independent or mutually exclusive project. However
the management should be cognizant of the inherent weaknesses of the techniques as well be aware
of non–financial factors that can affect the potential cash flows and other estimates used in the
analysis.

Each project may require a tailor made capital budgeting approach to suit the project specific features.
There are five commonly used capital budgeting techniques, which are:

 Payback method

 Discounted payback method

 Net present value

 Internal rate of return

Payback Method
This is the simplest method to evaluate a project. Payback period is the period where the cash inflow
equals to the initial project investment (cash outflow).

A project(s) is selected based on the firm’s objectives on the payback period. Disadvantages of this
method are:

1. It does not consider the cash inflow after the payback period. Hence, a project, which has
higher cash inflow after the payback period, may not be selected.
2. It does not consider the time value of money. Projects, which have same payback periods,
may have different cash inflows.

The figure below shows an example of the payback method.

NET CASH FLOW PAYBACK PERIOD FOR PROJECT X AND Y

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A capital budgeting choice needs to be made on 2 projects X and Y, which has a similar project period
of 4 years. If the projects are independent, should we consider the project? If the projects are mutually
exclusive, which is the preferred project?

Using the payback method period, project X recovers its initial outlay after year 2 and project Y
recovers after year 3.

Discounted Payback Method

The figure below shows an example of the payback method.

NET CASH FLOW DISCOUNTED PAYBACK PERIOD FOR PROJECT X AND Y

Figure 2: Example of Discounted Payback Method

Using the discounted cash flow method, project X recovers cumulative discount CF after 2 years and
project Y recovers cumulative discount CF after 3 years.

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Net Present Value
This method takes into account the time value of money. NPV is the amount (RM) of change in the
discounted value of the firm or project undertaken. NPV may be zero, negative or positive values. Zero
value indicates that the firm’s value does not change as a result of undertaking the project. This is
because the project generates the expected rate of return set by the firm.

Positive value of NPV indicates that the project generates more than the expected required rate of
return. Negative NPV value indicates the project generates less than the required rate of return. NPV
method is used to accept or reject independent projects, and to rank mutually exclusive projects.

The figure below shows an example of net present value.

Figure 3: Net present Value Profiles: NPVs of Projects X and Y at Different Costs of Capital

Using the NPV as criteria, the NPV of project X ranges from RM180.42 at 5% to RM (8.33) at 15%
discount rate. Similar NPV of project Y ranges from RM206.50 at 5% to RM (80.14) at 15% discount
rate.

Based on the criteria, both projects can be accepted at 5% since NPVs are positive and rejected at
15% as these are negative. At the crossover rate, NPVx = NPVy. If the discount rate is less than
crossover rate, project is preferred (NPVx > NPVy).

On the contrary, if the discount rate is greater than crossover rate, project Y is preferred (NPVy >
NPVx). The internal rate of return (IRR) is determined when NPV = 0. In this illustration, IRRx of
14.5% > IRRy of 11.8%. Based on the IRR, project X is preferred.

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Internal Rate of Return
This method considers the time value of money. It is similar to NPV method, except that the results are
expressed in percentages and not RM. If the rate of return is higher than or equal to the required rate
of return set by the management (hurdle rate), the project is accepted. The rate of return of a project is
calculated using trial and error method (by solving the value of k in the IRR formula so that NPV is
zero).

Evaluating NPV Estimates

The Basic Problem

Computing an NPV is putting a market value on uncertain future cash flows. Projecting the future
involves the potential for error. Major error sources are biases and omissions.
There are two main reasons for positive NPVs: (1) we have constructed a good project or (2) we have
done a bad job of estimating NPV.
Similarly, a negative computed NPV might be reflective of a bad project or of a bad job of estimating
NPV.

Projected versus Actual Cash Flows

Estimated cash flows are expectations of averages of possible cash flows, not exact figures (although
if an exact figure were available, you would use it).

i. Forecasting Risk

Forecasting risk – the danger of making a bad (value destroying) decision because of
errors in projected cash flows. This risk is reduced if we systematically investigate
common problem areas.

ii. Sources of Value

The first and best guard against forecasting risk is to keep in mind that positive NPVs are
economic rarities in competitive markets. In other words, for a project to have a positive NPV, it
must have some competitive edge – be first, be best, be the only. Keep in mind the economic
axiom that in a competitive market excess profits (the source of positive NPVs) are zero.

Scenario and Other What-If Analyses

Scenario Analysis

Worst-case/Best-case scenarios: putting lower and upper bounds on cash flows. Common exercises
include poor revenues/high costs and high revenues/low costs. Note that a thorough scenario
analysis starts with Base-case/Worst-case/Best-case and then expands from there.

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If, under most circumstances, the discounted projected cash flows are sufficient to cover the outlay,
we can have a high level of confidence that the NPV is positive. Beyond that, it is difficult to interpret
the meaning of the scenarios.

Sensitivity Analysis

To conduct a sensitivity analysis, hold all projections constant except one; alter that one, and see how
sensitive cash flow is to the change – the point is to get a fix on where forecasting risk may be
especially severe. You may want to use the worst-case/best-case idea for the item being varied.
Common exercises include varying sales, variable costs, and fixed costs.

Simulation Analysis

Computers are used to estimate thousands of possible scenarios. The interactions between variables
are estimated and incorporated into the model. We can then get an estimate of the probability
distribution for the NPV.

Care must be exercised to accurately assess the interaction between variables. The old computer
acronym, GIGO (garbage in, garbage out), still holds. The probability distribution is worse than useless
if we are careless in defining the model.

Summary

Capital budgeting as an investment decision is explained by identifying appropriate capital investment

Questions

You are analyzing a proposed project and have compiled the following information:

Year Cash flow

0 -$145,000

1 $ 33,400

2 $ 70,500

3 $ 82,100

Required payback period 3 years

Required return 9.50 percent

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1. What is the net present value of the proposed project?

2. What is the discounted payback period?

3. Should the project be accepted based on the internal rate of return (IRR)? Why or why not?