# Reading: Capital Budgeting

What
is Capital Budgeting?

•Capital
budgeting is the process in which a business determines and evaluates potential
expenses or investments that are large in nature. These expenditures and
investments include projects such as building a new plant or investing in a
long-term venture. Often times, a prospective project's lifetime cash inflows
and outflows are assessed in order to determine whether the potential returns
generated meet a sufficient target benchmark, also known as "investment
appraisal.“

•Ideally,
businesses should pursue all projects and opportunities that enhance
shareholder value. However, because the amount of capital available at any
given time for new projects is limited, management needs to use capital
budgeting techniques to determine which projects will yield the most return
over an applicable period of time. Various methods of capital budgeting can
include throughput analysis, net present value (NPV), internal rate of return
(IRR), discounted cash flow (DCF) and payback period.

Throughput
Analysis

•Throughput
is measured as the amount of material passing through a system. Throughput
analysis is the most complicated form of capital budgeting analysis, but is
also the most accurate in helping managers decide which projects to pursue.
Under this method, the entire company is considered a single, profit-generating
system.

•

•The
analysis assumes that nearly all costs in the system are operating expenses,
that a company needs to maximize the throughput of the entire system to pay for
expenses, and that the way to maximize profits is to maximize the throughput
passing through a bottleneck operation. A bottleneck is the resource in the
system that requires the longest time in operations. This means that managers
should always place higher consideration on capital budgeting projects that
impact and increase throughput passing though the bottleneck.

•This
does not mean that all other capital budgeting proposals will be rejected,
since there are a multitude of possible investments that can reduce costs
elsewhere in a company, and which are therefore worthy of consideration.
However, throughput is more important than cost reduction, since throughput has
no theoretical upper limit, whereas costs can only be reduced to zero. Given
the greater ultimate impact on profits of throughput over cost reduction, any
non-bottleneck proposal is simply not as important.

Discounted
Cash Flow Analysis

•Any
capital investment involves an initial cash outflow to pay for it, followed by
a mix of cash inflows in the form of revenue, or a decline in existing cash
flows that are caused by expenses incurred. We can lay out this information in
a spreadsheet to show all expected cash flows over the useful life of an
investment, and then apply a discount rate that reduces the cash flows to what
they would be worth at the present date. This calculation is known as net
present value. Net present value is the traditional approach to evaluating
capital proposals, since it is based on a single factor – cash flows – that can
be used to judge any proposal arriving from anywhere in a company.

•For
example, ABC Company is planning to acquire an asset that it expects will yield
positive cash flows for the next five years. Its cost of capital is 10%, which
it uses as the discount rate to construct the net present value of the project.
The following table shows the calculation:

Discounted
Cash Flow Analysis

Payback
Analysis

•The
simplest and least accurate evaluation technique is the payback method. This
approach is still heavily used, because it provides a very fast “back of the
envelope” calculation of how soon a company will earn back its investment. This
means that it provides a rough measure of how long a company will have its
investment at risk, before earning back the original amount expended. Thus, it
is a rough measure of risk. There are two ways to calculate the payback period,
which are:

•

•Simplified.
Divide the total amount of an investment by the average resulting cash flow.
This approach can yield an incorrect assessment, because a proposal with cash
flows skewed far into the future can yield a payback period that differs
substantially from when actual payback occurs.

•Manual
calculation. Manually deduct the forecasted positive cash flows from the
initial investment amount, from Year 1 forward, until the investment is paid
back. This method is slower to calculate, but ensures a higher degree of
accuracy.

Net
Present Value

•Net
Present Value (NPV) is the difference between the present value of cash inflows
and the present value of cash outflows. NPV is used in capital budgeting to
analyze the profitability of a projected investment or project.

•A
positive net present value indicates that the projected earnings generated by a
project or investment (in present dollars) exceeds the anticipated costs (also
in present dollars). Generally, an investment with a positive NPV will be a
profitable one and one with a negative NPV will result in a net loss. This
concept is the basis for the Net Present Value Rule, which dictates that the
only investments that should be made are those with positive NPV values.

Internal
Rate of Return

•Internal
rate of return (IRR) is a metric used in capital budgeting measuring the
profitability of potential investments. 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.

•Generally
speaking, the higher a project's internal rate of return, the more desirable it
is to undertake the project. IRR is uniform for investments of varying types
and, as such, IRR can be used to rank multiple prospective projects a firm is
considering 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.

Last modified: Tuesday, August 14, 2018, 8:51 AM