The Use Of Capital Budgeting Methods

Published Date: 02 Nov 2017

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Capital Budgeting techniques

Introduction

Capital budgeting is playing a key role in financial management strategy of all organizations.

Gitman (2007) determines the capital budgeting as the "process of evaluating and selecting long term investments that are consistent with the business’s goal of maximizing owner wealth". Usually every organization which decides to start this process has to take all steps needed to make sure that the criteria they chose for decision making backs up their business strategy and improves the competitive advantage of the business over its greatest rivals. If the business recognizes that its competitive advantage derives from its resources and from the way it makes decisions in relation to the use of its resources, as for instance financial resources, then it should motivate the managers to undertake informed decisions. Managers worldwide have evolved both systematic and non-systematic ways in order to handle capital budgeting procedures within their organization. Nowadays information and informed research are mostly but not in every case the basis of the managerial decisions due to the extremely competitive environment.

Within financial management capital budgeting is considered as one of the most important areas. There are many techniques to evaluate capital budgeting projects among which the most commonly used ones are the following: present value, payback period, internal rate of return, accounting rate of return and profitability index. Some of the recent studies show that financial managers all over the world prefer methods such as the internal rate of return or non-discounted payback period models over the net present value, which is mostly considered as the highest ranked method among the model academics. Findings also demonstrate that the larger businesses prefer the more complex methods such as IRR and NPV in contrast to the smaller businesses, which fact is also underlined by the experiences of the author which he gained during working for a huge international company.

The use of capital budgeting methods

Many different capital budgeting methods exist. As mentioned before, the approach of using net present value which calculates with discounted cash flows is regularly advocated in financial management textbooks. As for instance Brealey and Myers (2003), who also have a chapter (Ch.5) in their book on "why net present value leads to better investment decisions than other criteria". NPV is favorable due to it includes all cash-flows generated by the investment together with the time value of money. The definition of Net Present Value according to Investopedia is that it is the difference between the present value of the cash inflows and the present value of the cash outflows. In calculating the net present value of projects, the cash flows which occur at various points in time are set for the time value of money applying a discount rate which is the minimum rate of return demanded for the project to be reasonable. Those projects that have net present values greater than zero usually could be acceptable whereas projects that have net present values less than zero are typically unacceptable. If a project gets rejected, it is rejected due to the fact that cash flows generated by that project will also be negative. NPV is applied in capital budgeting in order to examine the profitability of a project or an investment. Net present value calculation is vulnerable to the reliability of future cash flows that the particular project or investment will yield. For example, the NPV contrasts the value of one unit in a given currency today to the value of the same unit and the same currency in the future while taking inflation and returns into consideration.

According to Investopedia, the internal rate of return (IRR) is defined as the discount rate often used in capital budgeting that makes the net present value of all cash flows from a certain project equal to zero. This actually means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or investment) equals its current market value (Stefan Yard 1999). A project could be said as more or less desirable according to its internal rate of return, the higher the better. As a result, a firm can rank several prospective considerable projects according to this. As such IRR provides a simple barrier, however any project should be avoided in case the cost of capital exceeds this rate. Internal rate of return is also sometimes cited as economic rate of return (ERR). Basic criteria of decision making could be to take on a project if its internal rate of return is higher than the cost of capital and reject in case the IRR does not reach the cost of capital. However it should be mentioned that the utilization of IRR could cause a number of complexities as it is a project with more IRRs or no IRR and also that IRR does not take the size of the project into consideration and assumes that cash flows are reinvested at a constant rate. Internal rate of return is the absolute opposite of net present value, because NPV is a discounted value of cash flows that yield from an investment. IRR on the other hand, calculates the break-even rate of return presenting the discount rate. The internal rate of return is often criticized together with the pay-back method. "IRR can be misleading when a choice must be made among mutually exclusive projects, and also because of so-called multiple rates of return (Ross et al., 2005), yet it is often used (Graham and Harvey, 2001; Brounen et al., 2004; Bennouna et al., 2010; Sandahl and Sjögren, 2003).

Payback methods do not consider the time value of money, and also ignores cash flows that occur after the maximum payback time (as defined by management), yet it is also often used (Graham and Harvey, 2001; Brounen et al., 2004; Bennouna et al., 2010; Sandahl and Sjögren, 2003). Discounted pay-back does not ignore the time value of money, but still ignores cash flows after the maximum pay-back point." (Daunfeldt, Hartwig, 2008)

The payback period could be defined as the time needed to recover the cost of the initial investment in a project from operations. According to Cooper(2001) the payback period as a capital budgeting method is used to assess capital projects and to compute the return per annum from the beginning of the project until the accumulated returns are equal to the cost of the investment at which time the investment is said to have been paid back and the time taken to achieve this payback is referred to as the payback period, furthermore the payback decision rule states that acceptable projects must have less than some maximum payback period designated by management. Payback is often used to underline the management’s concern with liquidity and the need to achieve the lowest risk possible through a quick reestablishment of the initial investment. It is regularly used for small expenditures which have evident benefits that the utilization of more sophisticated capital budgeting methods is not justified nor required.

It should be also mentioned that the desirable payback period defines the threshold barrier for accepting a given project. It regularly occurs in many cases that defining the desirable payback period is based on subjective assessments, which naturally take experiences of the past and the foreseeable level of project risk into consideration. The payback period has shown to be an important, popular, primary and traditional method in the developed nations like the UK and the USA (Pike 1985).

The price/earnings otherwise called earnings multiple method is a kind of pay-back method because it computes how many years it will take until the initial investment, which in this case is the share price, will be paid back by earnings. It takes earnings into consideration instead of cash flows and only takes one earnings figure into consideration, and again does not consider the time value of money. On the contrary, this particular valuation method has the benefit of letting the more or less efficient capital market guide the decision.

Another method is the accounting rate of return method. The main disadvantage of that is the fact that it uses accounting figures instead of cash-flows and does not take the time value of money into consideration either. It should be noted that the management can affect accounting numbers positively even though their actions may have negative effects on long-term value (Graham et al., 2005).

One of the more advanced techniques is the sensitivity analyses, which basically has no drawbacks, and could be used to see whether an investment would still be profitable in case one or more variables are changed. A different method with no noticeable disadvantage is real options. It has been already suggested that the reason why many projects that may look unprofitable at first glimpse are made regardless is that management explicitly or implicitly calculated with the possibility of making subsequent investments during the project evaluation. Value-at-risk, measuring "the worst expected loss over a given horizon under normal market conditions at a given confidence level" (Jorion, 2006), is a rather new method. A disadvantage is that is does not compute how bad the loss can be if conditions of the market would turn abnormal.

Profitability index is defined by the highest net present value per monetary unit of the initial outlay. "A potential limitation is that, if applied carelessly and investment resources are constrained, it can give bad advice" (Brealey and Myers, 2003).

The adjusted present value method adds the value of any financial side-effects of an investment to NPV, and should in principle have no drawbacks (Ross et al., 2005). The annuity method is also a kind of NPV. If the annuity of an investment is and the number of years it should generate net cash in- or outflows is known, then its NPV easily can be calculated by discounting the annuity with the relevant WACC.

Summary

The payback period and the discounted payback period methods are providing figures about the time it takes for a project to recover the initial investment. These two methods have the disadvantage that they do not necessarily consider all cash flows coming from a project. Furthermore, no objective criteria are given in order to judge a project, except for the simple criterion that the given project has to pay back. Both the net present value method and the profitability index consider all cash flows related to a project and do take discounting into consideration, which includes the time value of money and risk. The net present value method gives an amount as a result which is the expected added value from investing in a given project. The profitability index, however, shows an indexed value which could be useful in ranking projects. The internal rate of return is the earnings on the investment. It is the discount rate which makes the net present value equal to zero. IRR is dangerous to implement when choosing between mutually exclusive projects or when there is a limit on capital spending. The modified internal rate of return is a return on the investment, assuming that cash inflows are reinvested at some rate other than the internal rate of return. This method manages to overcome the problems which are associated with the internal rate of return method regarding unrealistic reinvestment rate assumptions. It has to be remembered though that, MIRR is dangerous to use when choosing between mutually exclusive projects or when there is a limit on capital spending. Each technique mentioned does have some advantages and disadvantages. The discounted flow techniques, including NPV, PI, IRR, and MIRR, are considered to be better than the non-discounted cash flow techniques including the payback period and the discounted payback period. In order to evaluate mutually exclusive projects or projects subject to capital rationing, the choice of technique must be very careful. The net present value method is consistent with owners' wealth maximization whether there are mutually exclusive projects or capital rationing. Looking at capital budgeting in practice, it can be seen that companies do use the discounted cash flow techniques, among these probably IRR is the most widely used one. Over time, however, a growing use of the net present value technique could be observed.

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