Running head: CAPITAL BUDGETING 1

Capital Budgeting Process for New Projects V. Replacement Decisions

CAPITAL BUDGETING 2

Abstract

This paper will show how companies and investors research the best way to start a new project

or replace an old one. How do they use three different methods and understanding their strengths

and weaknesses of relying on each of the methods alone. It also shows how their formulas are

related to WACC and how it increases their company's benefit, especially when an investor joins

in on the project.
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Capital Budgeting Process for New Projects V. Replacement Decisions

The capital budgeting process is a critical investment appraisal performed every time a

new project(s) wants to implement. In a nutshell, we may refer to it as a planning process that

determines the viability of a project by establishing what it will add or remove from the

company’s capitalization structure [CITATION Har12 \l 1033 ]. It is a necessary process that tells

whether a project will benefit the company and how much it will earn for a business. Capital

budgeting involves choosing projects that add value to a company. The capital budgeting process

can involve acquiring land or purchasing fixed assets like a new truck or machinery.

When a firm presented with a capital budgeting decision, one of its first tasks is to

determine whether the project will prove profitable. The payback period (PB), internal rate of

return (IRR) and net present value (NPV) are the most common methods that used to determine

the project's success and how much it would gain for the company with contradictory results.

Capital budgeting is the process a business undertakes to evaluate potential major projects or

investments. Construction of a new plant or a significant investment in an outside venture are

examples of projects that would require capital budgeting before they are approved or rejected.

The capital budgeting process is essential because capital budgeting influences the firm's

growth in the long run; it involves the risk of the firm, involves a commitment of a large number

of funds, and the decisions are irreversible or reversible at a substantial loss. Depending on

management's preferences and selection criteria, more emphasis will put on one approach over

another. Nonetheless, there are universal advantages and disadvantages associated with these

widely used valuation methods.

The Three Approaches to a project

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The payback(PB) is a period, defined as the number of years required to recover the

funds invested in a project from its cash flows. It starts with the project's cost and a negative

value, and then adds the cash inflow for each year until the cumulative cash flow becomes

positive. The payback year is the year before full recovery plus a fraction equal to the shortfall at

the end of that year divided by the cash flow during the full recovery year. The equation is

Payback = number of years before full recovery + Uncovered cost at the start of year/cash flow

during full recovery year. For example, let us say a company wants to start a project that will cost

$120 million to start, but the company kept gaining $50 million every year for five years.

The shorter the payback is, the better the project. Therefore, if the firm requires a

payback of less time than another project, it means that it will pursue that project. However, The

payback has three flaws

All dollars received in different years remain given the same weight (i.e., the time value of

money ignored);

cash flows beyond the payback year given no consideration regardless of how large they might

be;

unlike the NPV, which tells us how much wealth a project adds, and the IRR tells us how much a

project yields over the cost of capital, the payback merely tells us when we will recover our

investment.
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The internal rate of return (IRR) is the discount rate that would result in a net present

value of zero. IRR is a metric used in capital budgeting to estimate the profitability of potential

investments. The internal rate of return is a discount rate that makes the net present value (NPV)

of all cash flows from a particular project equal to zero. IRR calculations rely on the same

formula as NPV does. A business needs to look at the IRR as the plan for future growth and

expansion. The formula and calculation used to determine the outcome of the business where;

0 = NPV = T∑t=1 (Ct/(1+IRR)^t)-C0

Ct=Net cash inflow during the period t

C0=Total initial investment costs

IRR=The internal rate of return

t=The number of periods

To calculate IRR using the formula, one would set NPV equal to zero and solve for the

discount rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be

calculated analytically and must instead be calculated either through trial-and-error or using

software programmed to calculate IRR. For example, let us say the company invested $250,000

on a project to help people lose weight. That company found many buyers that they started to

gain the money they invested in the project

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As the company started gaining money, they were able to gain 57% of their investment back at a

good speed that they started gaining more investors and shareholders. The higher a project's

internal rate of return, the more desirable it is to undertake. IRR is uniform for investments of

varying types and, as such, IRR can be used to rank multiple prospective projects on a relatively

even basis. Assuming the costs of investment are equal among the various projects, the project

with the highest IRR would probably be considered the best and undertaken first. The initial

investment is always negative because it represents an outflow. The primary advantage of

implementing the internal rate of return as a decision-making tool is that it provides a benchmark

figure for every project that can assess a company's capital structure. The IRR will usually

produce the same types of decisions as net present value models and allows firms to compare

projects based on returns on invested capital.

However, IRR limitations IRR is a prevalent metric in estimating a project's profitability,

and it can be misleading if used alone. Depending on the initial investment costs, a project may

have a low IRR but a high NPV, meaning that while the pace at which the company sees returns

on that project may be slow, the project may also be adding a great deal of overall value to the

company. A short-duration project may have a high IRR, making it appear to be an excellent

investment, but it may also have a low NPV.

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The net present value approach is the most intuitive and accurate valuation approach to

capital budgeting problems. NPV is used in capital budgeting and investment planning to analyze

the profitability of a projected investment or project.

The formula of NPV is: NPV=n ∑t=1(Rt/(1+i)^t

where:

Rt =Net cash inflow outflows during a single period

ti=Discount rate of return that could earn in alternative investments

t=Number of timer periods

Discounting the after-tax cash flows by the weighted average cost of capital allows

managers to determine whether a project will be profitable or not. Moreover, unlike the IRR

method, NPVs reveal precisely how profitable a project will compare to alternatives. The NPV

rule states that all projects with a positive net present value should be accepted, while those that

are negative should reject. If funds are limited and all positive NPV projects cannot be initiated,

those with the high discounted value should be accepted.

Some of the NPV approach's significant advantages include its overall usefulness, and the

NPV provides a direct measure of added profitability. It allows one to compare multiple mutually

exclusive projects simultaneously, and even though the discount rate is subject to change, a

sensitivity analysis of the NPV can typically signal any overwhelming potential future concerns.
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For example, a company had two options to create plastic bottles that can keep fresh water.

Project A was for the company to hire plastic bottle manufacture to create the bottle; meanwhile,

project B was for the company to build its bottle. As the numbers show that project B would earn

money back and more within five years, but project A was not good for the company.

Internal rate of return (IRR) is very similar to NPV except that the discount rate is the rate

that reduces the NPV of an investment to zero. This method used to compare projects with

different lifespans or amounts of required capital. However, it has its drawbacks. An investment's

profitability with NPV relies heavily on assumptions and estimates, so there can be substantial

room for error. A project may often require unforeseen expenditures to get off the ground or may

require additional expenditures at the project's end. Payback period, or "payback method," is a

simpler alternative to NPV. The payback method calculates how long it will take for the original

investment to repay. A drawback is that this method fails to account for the time value of money.

For this reason, payback periods calculated for longer investments have a more significant

potential for inaccuracy.

New Project Vs. Replacement decision

Two types of projects can be distinguished: expansion projects, where the firm invests,

and replacement projects, where the firm replaces existing assets, generally to reduce costs.

[CITATION Eug17 \p 402 \l 1033 ] The company should analyze the past trend concerning
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ascertainment of the cash flow structure of the company, and determine the growth rate to the

cash flows and predict the future cash flow of the company’s projects. The cost of capital is

predicted by assigning weights to the cost of equity and the cost of debt, and the interest element

is to deducted with corporate taxes during the calculation of the post-tax cost of debt. They

should use the net present value method by discounting cash flows to the present by using the

cost of capital as a discounting rate. The company should compare the cash outflow with the cash

inflow to find out the net cash flow according to NPV since investors use it to look at the WACC

because it will help them invest in the project to gain more profit.

Conclusion

Capital budgeting is used by companies to evaluate significant projects and investments,

such as new plants or equipment. The process involves analyzing a project’s cash inflows and

outflows to determine whether the expected return meets a set benchmark. The significant

methods of capital budgeting include throughput, discounted cash flow, and payback analyses.
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References

Bierman, H., & Smidt, S. (2012). The Capital Budgeting Decision. Taylor & Francis.

Brigham, E. F., & Houston, J. F. (2017). Fundamentals of Financial Management. Gainesville:

Warrington College of Business.