Capital Budgeting: the key numerical techniques

Worked Examples with Explanations

The purpose behind capital budgeting is to assist managers of organisations make better
informed decisions on acquiring and disposing of assets. For example, how and when would you
know, without some form of detailed analysis, whether and when to buy a new machine for your
factory; or a new vehicle to deliver your goods; or even new land on which to build an extension
to your showrooms?

Although there are many aspects to capital budgeting other than the numerical aspects, it is these
aspects with which this page is solely concerned. The output of any of the following techniques
tells us whether a project is viable - in financial terms only.

Additionally, although I have said that capital budgeting is concerned with acquiring and
disposing of assets, I will not be giving examples relating to disposals in this page. The
techniques can easily be applied to such situations; and if you are interested in following through
to disposals either let me know or look for financial management texts in a good library which
contain examples of disposals.

The key numerical techniques to be covered in this page are:

 The Net Present Value Technique (NPV)

 The Internal Rate of Return Technique (IRR)

 The Payback Period Technique (PB)

 The Accounting Rate of Return Technique (ARR)

 The Profitability Index (PI)

I will deal with each one in turn.

Net Present Value

The idea behind the NPV technique is that it DISCOUNTS the cash flows generated by an asset
back to the present day: thus the NPV technique is concerned with the time value of money. The
result we are faced with is usually in the form:

Cash Discount Present

Year Flows Factors Values
(£) (15%) (£)
0 -25,0001.0000 -25,000.00
1 20,000 0.8696 17,391.30
2 25,000 0.7561 18,903.59
3 12,500 0.6575 8,218.95
4 9,000 0.5718 5,145.78
Net Present Value    24,659.63
The residual value is taken to be zero.

The key points to notice here are that we are dealing with the NET present value which is the net
of the initial (original) cost and the present value of all other cash flows. This is as opposed to the
present value of the cash flows which would simply be the sum of 17,319.30 + 18,903.59 ... +
5,145.78 = 49,659.63

Thus we are dealing with the value, in terms of today's prices, of an asset for which we are
expecting to pay £25,000 today. A positive NPV of £24,659.63 says that we are being asked to
pay £25,000 for an asset worth £49,659.63: a bargain!! Had the NPV been negative - let's say
MINUS £24,659.63 - then we would not be facing such a bargain. In this example, a negative
NPV of the value just given would say we were being asked to pay £25,000 for an asset worth
only £340.37: definitely not a bargain.

The above example is a case of a CONVENTIONAL investment. A conventional investment is

one where an initial outflow of cash (the original capital cost) is followed by positive inflows. A
non conventional investment would behave differently: for example, it could have several
negative initial outflows followed by some positive and some negative inflows:

Year Conventional Non

Investment conventional
Investment
0 Negative Negative
1 Positive Negative
2 Positive Positive
3 Positive Positive
4 Positive Negative
5 Positive Positive
6 Positive Positive
The fact that an investment is non conventional does not alter the way the NPV technique works:
it is merely another fact for you to impress your friends with!!

Internal Rate of Return

In some senses this is the simplest of the techniques to understand. However, it is the most
difficult to cope with mathematically. The best way of viewing the IRR of a project is to consider
it in the form of a graph: the NET PRESENT VALUE PROFILE:

Construct a Net Present Value Profitle for yourself!

Reading from the point where the NPV profile itself cuts the horizontal (interest rate) axis gives
the value of the IRR - in this case it is 66.15%.

By appreciating that this is how to find the value of the IRR, you can, in fact, define the term
yourself: it is the rate of interest applying to a project at which its net present value is precisely
zero. The usefulness of this knowledge is that if the IRR is known (and it is relatively simple to
discover it for any project with either a good calculator or a computer) then, for any rate of
interest which the company has to bear, the management will know whether the project under
review is a good one, a risky one or a safe one.

In the example above, then, if the current interest rate being borne by that company is 15% on
average, then it knows, with an IRR of 66.15% that interest rates will have to rise a long way
before this project becomes non viable. It follows from this that, in general, if the rate of interest
being borne or considered is LESS THAN the IRR, the net present value of the project is sure to
be positive; and similarly, if the rate of interest is GREATER THAN the IRR, the NPV is sure to
be negative.

Confirm the last few statements by inspecting the NPV profile and considering the numerical
aspects of that example for yourself.

The Payback Period

In spite of what I said above about the IRR technique being the simplest to understand of all the
techniques being presented here, in fact, PB outshines them all for simplicity - once you have got
used to it!!

The payback period is measures the length of time it takes a project to repay its initial capital
cost. For example, if I buy a machine for £10,000 and it earns me a cash flow of £10,000 for the
whole of the first year of its life, I can see immediately that the cash flows have repaid the initial
capital cost and therefore that the payback period is exactly one year.

If the same machine gave rise to £5,000 cash flow in the first year and £5,000 cash flow in the
second year then the payback period has become two years since that is how long it has taken
cumulative cash flows to equal the initial capital cost. Developing that idea more generally now,
let's go back to our original example above:

Cumulative
Yea Cash
Cash
r Flows
Flows
0 -25,000-25,000
1 20,000 - 5,000
2 25,000 20,000
3 12,500 32,500
4 9,000 41,500
When, in the above example, does the cumulative cash flow equal £0? It isn't immediately
obvious but we can see that it is somewhere between year one and year two: at the end of year
one cumulative cash flows equal £-5,000; and at the end of year two they equal £20,000;
therefore somewhere between the two they have been equal to £0. But where? We can find out
exactly where providing we assume that all cash flows accrue evenly throughout the year: in year
two, £20,000 has been received by the company and we assume that £20,000/365 was the daily
cash flow.

The payback period calculation is:

The cash flow received

Number of years
immediately prior to the year
PLUS
in which the payback
period occurs
In our example, this is:
during the year to take
cumulative cash flow to zero
The total cash flow during the
year during which the payback
period occurs

1 year
+
£5,000
years =
1.25
years
£20,000
This will seem a very awkward way of dealing with a fairly simple calculation; and once you
have practiced it you'll find it is a simple technique to use.

The payback period technique is the single most widely used technique of all of the techniques
currently reported to be in use virtually anywhere in the world! It is so widely used for two major
reasons:

 it is the simplest method available

 it acts as a proxy for risk.

The first reason should be self explanatory. The second reason may need some explanation. The
method is a proxy for risk in that most people are risk averse - they do not like taking risks - and
thus they prefer to minimise or offset risk altogether.

Risk arises in capital budgeting in that most of the data on which decisions are based are
estimated - especially the data derived for the later years of a project - the further away from
today a value for cash flow is, the less reliable it is (that is, the more risky it would be to believe
it and act on it). The beauty of the payback period technique in this respect is that it tells
management how quickly its cash inflows cover its cash outflows: the quicker the better. Hence,
a decision will be favourable on a project with a lower value for the payback period when a
manager is risk averse.

In reality, a value of between 3 and 5 seems to be the sort of value which most British managers
wish to see: an average British manager is risk averse!

Accounting Rate of Return

The only method of the five we are discussing which relies on PROFIT rather than cash flows.
Nevertheless, its calculations re not too onerous. Again, we'll work through the same example
we've been considering so far for the other techniques.

Total Annual
Initial Net ARR
Cash Depreciation Average
Cost Profit %
Flows Profit
25,000 66,500 25,000 41,500 10,375 41.50
Note: depreciation is equal to the initial cost of the asset because we were told that there is to be
a zero residual value at the end of the life of the asset: otherwise, the depreciation would have
been initial cost less residual value.

The result of 41.50% is the average annual rate of profit earned by this asset or project and it can
be compared with other projects: the higher the rate of profit earned the better.
The Profitability Index

Of itself, this method is nice and straightforward; BUT, to calculate the PI, you have first to
calculate the NPV - then it's easy!! From our continuing example, the PI is:

(i) Net Present

Value
Initial Capital Cost
Alternatively, you can calculate it as:

(i) Present Value

Initial Capital Cost
Although the values derived from each calculation are different, their interpretations are the
same:

(i) £24,659.63 = 0.9864

£25,000

(ii) £49,659.63 = 1.9864

£25,000

The PI is relative view of how well a project is to perform: it compares NPV or PV (depending
on whether you're using equation (i) or (ii)) with the initial capital cost. There is no single value
which will tell you whether the project is a good one: rather, two or more projects may be being
considered and the PI which is highest belongs to the optimal project to adopt.

The above has given an insight into the five methods you are most likely to face in theory as well
as in practice. One thing we have not done here is to consider the advantages and disadvantages
of these methods: a later page will describe these.

Exercises

You might care to work through the following exercises to confirm your understanding of the
above techniques (except the IRR technique). I will give you the result for the IRR for each
exercise.

Q1

Cash
Year
Flows
0 -50,000
1 13,000
2 12,000
3 5,000
4 5,000
5 3,000
The rate of interest is to be 12%

Q2

Cash
Year
Flows
0 -45,000
1 13,000
2 13,000
3 13,000
4 13,000
There is estimated to be a residual value of £10,000 receivable at the end of year 5; and the rate
of interest is to be taken as 14%.

For exercise 1, the IRR is 23.03%; and for exercise 2 it is 12.81%.

Capital budgeting (or investment appraisal) is the planning process used to determine whether a
firm's long term investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing. It is budget for major capital, or
investment, expenditures.[1]

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

 Accounting rate of return

 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annuity

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

Main article: Net present value

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find
its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher
separation theorem, 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 [disambiguation needed] to determine their present value. These present values are then summed, to
get the NPV. See also Time value of money. 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 rate, so selecting the proper rate - sometimes called the
hurdle rate - is critical to making the right decision. The hurdle rate is the minimum acceptable return on
an investment. It should reflect the riskiness of the investment, typically measured by the volatility of
cash flows, and must take into account the financing mix. Managers may use models such as the CAPM
or the APT to estimate a discount rate appropriate for each particular project, and use the weighted
average cost of capital (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.

[edit] Internal rate of return

Main article: Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (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 Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV [citation
needed]
, 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.

[edit] 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.Y

[edit] Real options

Main article: Real options analysis

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 try to value the choices - the option value - that
the managers will have in the future and adds these values to the NPV.

[edit] 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.

[edit] 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 stock, and common
stock. The ideal mix of those funding sources is determined by the financial managers of the firm and is
related to the amount of financial risk 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.