Capital budgeting is the planning process used to determine whether an organization's long term
investmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
s such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major
capitalIn economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
, or investment, expenditures.
Many formal methods are used in capital budgeting, including the techniques such as
- Accounting rate of return
Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a...
- Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
- Profitability index
Profitability index , also known as profit investment ratio and value investment ratio , is the ratio of payoff to investment of a proposed project...
- Internal rate of return
The internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
- Modified internal rate of return
The modified internal rate of return is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size...
- Equivalent annuity
In finance the equivalent annual cost is the cost per year of owning and operating an asset over its entire lifespan.EAC is often used as a decision making tool in capital budgeting when comparing investment projects of unequal lifespans...
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 investmentReturn on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
." Simplified and hybrid methods are used as well, such as
payback periodPayback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account...
and
discounted payback period.
Net present value
Each potential project's value should be estimated using a
discounted cash flowIn finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
(DCF) valuation, to find its
net present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
(NPV). (First applied to
Corporate FinanceCorporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
by
Joel DeanJoel Dean is best known for his contributions to Corporate Finance theory in general, and particularly to the area of Capital budgeting. He is regarded as one of the founders of business economics...
in 1951; see also
Fisher separation theoremIn economics, the Fisher separation theorem asserts that the objective of a corporation will be the maximization of its present value, regardless of the preferences of its shareholders. The theorem therefore separates management's "productive opportunities" from the entrepreneur's "market...
, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project. These future cash flows are then discounted to determine their
present valuePresent value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
. These present values are then summed, to get the NPV. See also
Time value of moneyThe time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory....
. The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV(GE).
The NPV is greatly affected by the
discount rateThe discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
, so selecting the proper rate - sometimes called the
hurdle rate - is critical to making the right decision. The hurdle rate is the minimum acceptable
returnReturn on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
on an investment.
It should reflect the riskiness of the investment, typically measured by the
volatilityIn finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
of cash flows, and must take into account the financing mix. Managers may use models such as the
CAPMIn finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
or the
APTIn finance, arbitrage pricing theory is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a...
to estimate a discount rate appropriate for each particular project, and use the
weighted average cost of capitalThe weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
(
WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.
Internal rate of return
The
internal rate of returnThe internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
(IRR) is defined as the
discount rateThe discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
that gives a
net present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
(NPV) of zero. It is a commonly used measure of investment efficiency.
The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.
In some cases, several zero NPV discount rates may exist, so there is no unique 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.
One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called
Modified Internal Rate of ReturnThe modified internal rate of return is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments of equal size...
(MIRR) is often used.
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV, although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.
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
NPVIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
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
inflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
, so a
real interest rateThe "real interest rate" is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate...
rather than a
nominal interest rateIn finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...
is commonly used in the calculations.Y
Real options
Real options analysis has become important since the 1970s as
option pricing modelsIn finance, a price is paid or received for purchasing or selling options. This price can be split into two components.These are:* Intrinsic Value* Time Value-Intrinsic Value:...
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 try to value the choices - the option value - that the managers will have in the future and adds these values to the
NPVNPV can refer to:* Net present value, an economic standard method for evaluating competing long-term projects in capital budgeting* Negative predictive value, in biostatistics, the proportion of patients with negative test results who are correctly diagnosed...
.
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 indexProfitability index , also known as profit investment ratio and value investment ratio , is the ratio of payoff to investment of a proposed project...
to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.
Funding Sources
When a corporation determines its capital budget, it must acquire said funds. Three methods are generally available to publicly traded corporations: corporate bonds,
preferred stockPreferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
, and
common stockCommon stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
. The ideal mix of those funding sources is determined by the financial managers of the firm and is related to the amount of
financial riskFinancial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
that corporation is willing to undertake. Corporate bonds entail the lowest financial risk and therefore generally have the lowest interest rate. Preferred stock have no financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders; they generally have interest rates higher than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects.
External links and references
- Capital Budgeting
- International Good Practice: Guidance on Project Appraisal Using Discounted Cash Flow, International Federation of Accountants
International Federation of Accountants is the global organization for the accountancy profession. IFAC has 164 member and associates in 124 countries and jurisdictions, representing more than 2.5 million accountants employed in public practice, industry and commerce, government, and academe...
, June 2008, ISBN 978-1-934779-39-2
- Prospective Analysis: Guidelines for Forecasting Financial Statements, Ignacio Velez-Pareja, Joseph Tham , 2008
- To Plug or Not to Plug, that is the Question: No Plugs, No Circularity: A Better Way to Forecast Financial Statements, Ignacio Velez-Pareja, 2008
- A Step by Step Guide to Construct a Financial Model Without Plugs and Without Circularity for Valuation Purposes, Ignacio Velez-Pareja, 2008
- Long-Term Financial Statements Forecasting: Reinvesting Retained Earnings, Sergei Cheremushkin, 2008