Capital budgeting

Last updated December 22, 2023

Capital budgeting in corporate finance, corporate planning and accounting is an area of capital management that concerns the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structures (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures.^[1] An underlying goal, consistent with the overall approach in corporate finance,^[2] is to increase the value of the firm to the shareholders.

Capital budgeting is typically considered a non-core business activity as it is not part of the revenue model or models of most types of firms, or even a part of daily operations. It holds a strategic financial function within a business. One example of a firm type where capital budgeting is plausibly a part of the core business activities is with investment banks, as their revenue model or models rely on financial strategy to a considerable degree.^[3]^[4]^[5]^[6]

For the budget allocated to ongoing expenses and revenue, see operating budget.

Techniques

Many formal methods are used in capital budgeting, including the techniques such as

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Net present value

Cash flows are discounted at the cost of capital to give the net present value (NPV) added to the firm. Unless capital is constrained, or there are dependencies between projects, in order to maximize the value added to the firm, the firm would accept all projects with positive NPV. This method accounts for the time value of money. For the mechanics of the valuation here, see Valuation using discounted cash flows.

Mutually exclusive projects are a set of projects from which at most one will be accepted, for example, a set of projects which accomplish the same task. Thus when choosing between mutually exclusive projects, more than one of the projects may satisfy the capital budgeting criterion, but only one project can be accepted; see below #Ranked projects.

Internal rate of return

The internal rate of return (IRR) is the discount rate that gives a net present value (NPV) of zero. It is a widely used measure of investment efficiency. To maximize return, sort projects in order of IRR.

Many projects have a simple cash flow structure, with a negative cash flow at the start, and subsequent cash flows are positive. In such a case, if the IRR is greater than the cost of capital, the NPV is positive, so for non-mutually exclusive projects in an unconstrained environment, applying this criterion will result in the same decision as the NPV method.

An example of a project with cash flows which do not conform to this pattern is a loan, consisting of a positive cash flow at the beginning, followed by negative cash flows later. The greater the IRR of the loan, the higher the rate the borrower must pay, so clearly, a lower IRR is preferable in this case. Any such loan with IRR less than the cost of capital has a positive NPV.

Excluding such cases, for investment projects, where the pattern of cash flows is such that the higher the IRR, the higher the NPV, for mutually exclusive projects, the decision rule of taking the project with the highest IRR will maximize the return, but it may select a project with a lower NPV.

In some cases, several solutions to the equation NPV = 0 may exist, meaning there is more than one possible IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.

IRR is the return on capital invested, over the sub-period it is invested. It may be impossible to reinvest intermediate cash flows at the same rate as the IRR. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is designed to overcome this issue, by simulating reinvestment of cash flows at a second rate of return.

Despite a strong academic preference for maximizing the value of the firm according to NPV, surveys indicate that executives prefer to maximize returns^{[ citation needed ]}.

Equivalent annuity method

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form, it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.

It is often used when comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.

The use of the EAC method implies that the project will be replaced by an identical project.

Alternatively, the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say, 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3-year project are compare to three repetitions of the 4-year project. The chain method and the EAC method give mathematically equivalent answers.

The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.

Real options

Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis tries to value the choices - the option value - that the managers will have in the future and adds these values to the NPV.

Ranked projects

The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.

Funding sources

Capital budgeting investments and projects must be funded through excess cash provided through the raising of debt capital, equity capital, or the use of retained earnings. Debt capital is borrowed cash, usually in the form of bank loans, or bonds issued to creditors. Equity capital are investments made by shareholders, who purchase shares in the company's stock. Retained earnings are excess cash surplus from the company's present and past earnings.

Each of these sources has its own characteristics re (i) the required rate of return expected by capital providers, with the consequent impact on overall cost of capital, as well as (ii) implications for cash flow. The "financing mix" selected will thus effect the valuation of the firm: Corporate finance § Capitalization structure discusses these two interrelated considerations .

Need

A large sum of money is involved, which influences the profitability of the firm, making capital budgeting an important task.
Long-term investments, once made, cannot be reversed without a significant loss of invested capital. The investment becomes sunk, and mistakes, rather than being readily rectified, must often be borne until the project can be withdrawn through depreciation charges or, in the worst case, liquidation of the firm. It influences the whole conduct of the business for years to come.
Investment decisions are the major decisions that will cause profit to be earned for the firm and will probably be measured through return on capital. A proper mix of capital investment is quite important to ensure an adequate rate of return on investment, which calls for capital budgeting.
The implications of long term investment decisions are more extensive than those of short-run decisions because of the time factor involved; capital budgeting decisions are subject to a higher degree of risk and uncertainty than short-run decisions.^[7]

Related Research Articles

The discounted cash flow (DCF) analysis, in finance, is a method used to value a security, project, company, or asset, that incorporates the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management, and patent valuation. Used in industry as early as the 1700s or 1800s, it was widely discussed in financial economics in the 1960s, and U.S. courts began employing the concept in the 1980s and 1990s.

The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the annual effective discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.

Internal rate of return (IRR) is a method of quantifying the merits of a project or investment opportunity. The calculation is termed internal because it depends only on the cash flows of the investment being analyzed and excludes external factors, such as returns available elsewhere, the risk-free rate, inflation, the cost of capital, or financial risk.

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.

Real options valuation, also often termed real options analysis, applies option valuation techniques to capital budgeting decisions. A real option itself, is the right—but not the obligation—to undertake certain business initiatives, such as deferring, abandoning, expanding, staging, or contracting a capital investment project. For example, real options valuation could examine the opportunity to invest in the expansion of a firm's factory and the alternative option to sell the factory.

<span class="mw-page-title-main">Valuation (finance)</span> Process of estimating what something is worth, used in the finance industry

In finance, valuation is the process of determining the value of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.

Adjusted present value (APV) is a valuation method introduced in 1974 by Stewart Myers. The idea is to value the project as if it were all equity financed ("unleveraged"), and to then add the present value of the tax shield of debt – and other side effects.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value. A target price is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings.

In economics and accounting, the cost of capital is the cost of a company's funds, or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.

The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.

Valuation using discounted cash flows is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach".

Cash-flow return on investment (CFROI) is a valuation model that assumes the stock market sets prices based on cash flow, not on corporate performance and earnings.

The following outline is provided as an overview of and topical guide to finance:

In finance, risk-adjusted net present value (rNPV) or expected net existing value (eNPV) is a method to value risky future cash flows. rNPV is the standard valuation method in the drug development industry, where sufficient data exists to estimate success rates for all R&D phases. A similar technique is used in the probability model of credit default swap (CDS) valuation.

The First Chicago method or venture capital method is a business valuation approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow (DCF) valuation approach.

Strategic financial management is the study of finance with a long term view considering the strategic goals of the enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to give it an increased frame of reference.

Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.

The following outline is provided as an overview of and topical guide to corporate finance:

References

↑ O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action . Upper Saddle River, New Jersey: Pearson Prentice Hall. pp. 375. ISBN 0-13-063085-3.
↑ See Corporate Finance: First Principles, Aswath Damodaran, New York University's Stern School of Business
↑ Pinkasovitch, Arthur. "An Introduction to Capital Budgeting". Investopedia. Retrieved 1 October 2022.
↑ Geijsbeek, William R. Jr.; Schall, Lawrence D.; Sundem, Gary L. (1978). "Survey and Analysis of Capital Budgeting Methods". The Journal of Finance. 33 (1): 281–287. doi:10.2307/2326365. JSTOR 2326365 . Retrieved 1 October 2022.
↑ Hub City Lending, 23 January 2023
↑ Mao, James C. T. (1970). "Survey of Capital Budgeting: Theory and Practice". The Journal of Finance. 25 (2): 349–360. doi:10.1111/j.1540-6261.1970.tb00513.x. JSTOR 2325481 . Retrieved 27 May 2023.
↑ Varshney, R.L.; K.L. Maheshwari (2010). Managerial Economics. New Delhi: Sultan Chand & Sons. p. 881. ISBN 978-81-8054-784-3.