WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty of a

financial manager is to choose investments with satisfactory
cash flows and rates of return. Therefore, a financial manager
must be able to decide whether an investment is worth
undertaking and be able to choose intelligently between two or
more alternatives. To do this, a sound procedure to evaluate,
compare, and select projects is needed. This procedure is called
capital budgeting.
I. CAPITAL IS A LIMITED ES!UCE
In the form of either debt or equity, capital is a very limited
resource. There is a limit to the volume of credit that the
banking system can create in the economy. Commercial banks
and other lending institutions have limited deposits from which
they can lend money to individuals, corporations, and
governments. In addition, the ederal !eserve "ystem requires
each bank to maintain part of its deposits as reserves. #aving
limited resources to lend, lending institutions are selective in
e$tending loans to their customers. %ut even if a bank were to
e$tend unlimited loans to a company, the management of that
company would need to consider the impact that increasing
loans would have on the overall cost of financing.
In reality, any firm has limited borrowing resources that
should be allocated among the best investment alternatives. One
might argue that a company can issue an almost unlimited
amount of common stock to raise capital. Increasing the number
of shares of company stock, however, will serve only to
distribute the same amount of equity among a greater number of
shareholders. In other words, as the number of shares of a
company increases, the company ownership of the individual
stockholder may proportionally decrease.
The argument that capital is a limited resource is true of any
form of capital, whether debt or equity &short'term or long'term,
common stock( or retained earnings, accounts payable or notes
payable, and so on. )ven the best'known firm in an industry or
a community can increase its borrowing up to a certain limit.
Once this point has been reached, the firm will either be denied
more credit or be charged a higher interest rate, making
borrowing a less desirable way to raise capital.
aced with limited sources of capital, management should
carefully decide whether a particular project is economically
acceptable. In the case of more than one project, management
must identify the projects that will contribute most to profits
and, consequently, to the value &or wealth( of the firm. This, in
essence, is the basis of capital budgeting.
"!U SH!ULD EMEMBE
Capital budgeting is investment decision'making as to whether a project is worth
undertaking. Capital budgeting is basically concerned with the justification of capital
e$penditures.
Current e$penditures are short'term and are completely written off in the same year that
e$penses occur. Capital e$penditures are long'term and are amorti*ed over a period of
years are required by the I!".
II. Ba#ic Step# $% Capital Budgeting
+. )stimate the cash flows
,. -ssess the riskiness of the cash flows.
.. /etermine the appropriate discount
rate.
0. ind the 12 of the e$pected cash
flows.
3. -ccept the project if 12 of inflows 4
costs. I!! 4 #urdle !ate and5or
payback 6 policy
De%initi$n#&
Independent versus mutually e$clusive
projects.
7ormal versus nonnormal projects.
Ba#ic Data
E'pected Net Ca#( )l$*
"ea+ P+$,ect L P+$,ect S
8
+
,
.
&9+88(
+8
:8
;8
&9+88(
<8
38
,8
III. E-aluati$n Tec(ni.ue#
-.1ayback period
%. 7et present value &712(
C. Internal rate of return &I!!(
/.=odified internal rate of return
&=I!!(
). 1rofitability inde$
A. PA"BAC/ PEI!D
1ayback period > )$pected number of
years required to recover a project?s cost.
P+$,ect L
E'pected Net Ca#( )l$*
"ea+ P+$,ect L P+$,ect S
8
+
,
&9+88(
+8
:8
&9+88(
&@8(
&.8(
. ;8 38
1ayback
A
> , B 9.859;8 years
> ,.0 years.
1ayback
"
> +.: years.
Wea0ne##e# $% Pa1bac0&
+. Ignores the time value of money. This
weakness is eliminated with the
discounted payback method.
,. Ignores cash flows occurring after the
payback period.
B. NET PESENT 2ALUE

= +
=
n
8 t
t
k( &+
t
C
712
P+$,ect L&
8 + , .
+88.88 +8 :8 ;8
@.8@
0@.3@
:8.++
712
A
> 9 +;.<@
712
"
> 9+@.@;
If the projects are independent, accept
both.
If the projects are mutually e$clusive,
accept 1roject " since 712
"
4 712
A
.
N$te& 712 declines as k increases, and
712 rises as k decreases.
C. INTENAL ATE !) ETUN
( )
712 98
n
8 t
t
I!! +
t
C
C I!! = =

= +
.
P+$,ect L&
;.0<
0..8,
0;.3<
9 8.8: 98
I!!
A
> +;.+D
I!!
"
> ,..:D
If the projects are independent, accept
both because I!! 4 k.
If the projects are mutually e$clusive,
accept 1roject " since I!!
"
4 I!!
A
.
8 + , .
+88.88 +8 :8 ;8
+;.+D
+;.+D
+;.+D
N$te& I!! is independent of the cost of
capital.
0 NP2
L
NP2
S
8D
3
+8
+3
,8
938
..
+@
<
&0(
908
,@
,8
+,
3
38
08
.8
,8
+8
8
'+8
3 +8 +3 ,8 ,3 k&D(
Crossover 1oint > ;.<D
I!!" > ,..:D
I!!A > +;.+D
712
&9(
+. -/2-7T-E)" -7/ /I"-/2-7T-E)" O I!! -7/
712
- number of surveys have shown that, in practice, the I!!
method is more popular than the 712 approach. The reason
may be that the I!! is straightforward, but it uses cash flows
and recogni*es the time value of money, like the 712. In other
words, while the I!! method is easy and understandable, it does
not have the drawbacks of the -!! and the payback period,
both of which ignore the time value of money.
The main problem with the I!! method is that it often gives
unrealistic rates of return. "uppose the cutoff rate is ++D and
the I!! is calculated as 08D. /oes this mean that the
management should immediately accept the project because its
I!! is 08D. The answer is noF -n I!! of 08D assumes that a
firm has the opportunity to reinvest future cash flows at 08D. If
past e$perience and the economy indicate that 08D is an
unrealistic rate for future reinvestments, an I!! of 08D is
suspect. "imply speaking, an I!! of 08D is too good to be trueF
"o unless the calculated I!! is a reasonable rate for
reinvestment of future cash flows, it should not be used as a
yardstick to accept or reject a project.
-nother problem with the I!! method is that it may give
different rates of return. "uppose there are two discount rates
&two I!!s( that make the present value equal to the initial
investment. In this case, which rate should be used for
comparison with the cutoff rateG The purpose of this question is
not to resolve the cases where there are different I!!s. The
purpose is to let you know that the I!! method, despite its
popularity in the business world, entails more problems than a
practitioner may think.
,. H#I T#) 712 -7/ I!! "O=)TI=)" ")A)CT
/I)!)7T 1!OJ)CT"
Hhen comparing two projects, the use of the 712 and the I!!
methods may give different results. - project selected according
to the 712 may be rejected if the I!! method is used.
"uppose there are two alternative projects, K and I. The
initial investment in each project is 9,,388. 1roject K will
provide annual cash flows of 9388 for the ne$t +8 years. 1roject
I has annual cash flows of 9+88, 9,88, 9.88, 9088, 9388, 9:88,
9<88, 9;88, 9@88, and 9+,888 in the same period. Lsing the
trial and error method e$plained before, you find that the I!! of
1roject K is +<D and the I!! of 1roject I is around +.D. If
you use the I!!, 1roject K should be preferred because its I!!
is 0D more than the I!! of 1roject I. %ut what happens to your
decision if the 712 method is usedG The answer is that the
decision will change depending on the discount rate you use.
or instance, at a 3D discount rate, 1roject I has a higher 712
than K does. %ut at a discount rate of ;D, 1roject K is preferred
because of a higher 712.
The purpose of this numerical e$ample is to illustrate an
important distinctionC The use of the I!! always leads to the
selection of the same project, whereas project selection using the
712 method depends on the discount rate chosen.
PROJECT SIZE AND LIFE
There are reasons why the 712 and the I!! are sometimes in
conflictC the si*e and life of the project being studied are the
most common ones. - +8'year project with an initial investment
of 9+88,888 can hardly be compared with a small .'year project
costing 9+8,888. -ctually, the large project could be thought of
as ten small projects. "o if you insist on using the I!! and the
712 methods to compare a big, long'term project with a small,
short'term project, don?t be surprised if you get different
selection results. &"ee the equivalent annual annuity discussed
later for a good way to compare projects with unequal lives.(
DIFFERENT CASH FLOWS
urthermore, even two projects of the same length may have
different patterns of cash flow. The cash flow of one project
may continuously increase over time, while the cash flows of the
other project may increase, decrease, stop, or become negative.
These two projects have completely different forms of cash
flow, and if the discount rate is changed when using the 712
approach, the result will probably be different orders of ranking.
or e$ample, at +8D the 712 of 1roject - may be higher than
that of 1roject %. -s soon as you change the discount rate to
+3D, 1roject % may be more attractive.
WHEN ARE THE NPV AND IRR RELIABLE?
Eenerally speaking, you can use and rely on both the 712
and the I!! if two conditions are met. irst, if projects are
compared using the 712, a discount rate that fairly reflects the
risk of each project should be chosen. There is no problem if
two projects are discounted at two different rates because one
project is riskier than the other. !emember that the result of the
712 is as reliable as the discount rate that is chosen. If the
discount rate is unrealistic, the decision to accept or reject the
project is baseless and unreliable. "econd, if the I!! method is
used, the project must not be accepted only because its I!! is
very high. =anagement must ask whether such an impressive
I!! is possible to maintain. In other words, management should
look into past records, and e$isting and future business, to see
whether an opportunity to reinvest cash flows at such a high I!!
really e$ists. If the firm is convinced that such an I!! is
realistic, the project is acceptable. Otherwise, the project must
be reevaluated by the 712 method, using a more realistic
discount rate.
"!U SH!ULD EMEMBE
The internal rate of return &I!!( is a popular method in capital budgeting. The I!! is a
discount rate that makes the present value of estimated cash flows equal to the initial
investment. #owever, when using the I!!, you should make sure that the calculated I!! is
not very different from a realistic reinvestment rate.
M$di%ied I 3MI4
The =I!! is similar to the I!!, but is theoretically superior
in that it overcomes two weaknesses of the I!!. The =I!!
correctly assumes reinvestment at the project?s cost of capital
and avoids the problem of multiple I!!s. #owever, please note
that the =I!! is not used as widely as the I!! in practice.
There are . basic steps of the =I!!C
&+( )stimate all cash flows as in I!!.
&,( Calculate the future value of all cash inflows at the last
year of the project?s life.
&.( /etermine the discount rate that causes the future
value of all cash inflows determined in step ,, to be equal
to the firm?s investment at time *ero. This discount rate is
know as the =I!!.
P+$,ect L&
8 + , .
'+88.88 +8 :8 ;8.88
::.88
+, .+8
9+3;.+8 > T2 of
inflows
+88 .88
9 8 .88 >
712
12 outflows > 9+88
T2 inflows > 9+3;.+8.
12costs >
( )
n
=I!! +
T2
+
+8D
=I!! > +:.3D
=I!!
"
> +:.@D.
=I!! is better than I!! because
+. =I!! correctly assumes reinvestment at project?s cost of
capital.
,. =I!! avoids the problem of multiple I!!s.
E. P!)ITABILIT" INDE5 3PI4
The p+$%itabilit1 inde', or 1I, method compares the present
value of future cash inflows with the initial investment on a
relative basis. Therefore, the 1I is the ratio of the present value
of cash flows &12C( to the initial investment of the project.
investment Initial
PVCF
PI =
In this method, a project with a 1I greater than + is accepted,
but a project is rejected when its 1I is less than +. 7ote that the
1I method is closely related to the 712 approach. In fact, if the
net present value of a project is positive, the 1I will be greater
than +. On the other hand, if the net present value is negative,
the project will have a 1I of less than +. The same conclusion is
reached, therefore, whether the net present value or the 1I is
used. In other words, if the present value of cash flows e$ceeds
the initial investment, there is a positive net present value and a
1I greater than +, indicating that the project is acceptable.
1I is also know as a benefit5cash ratio.
P+$,ect L
8 + , .
'+88.88 +8 :8 ;8
12
+
@.8@
12
,
0@.3@
12
.
:8 .++
++;.<@
+8D
coast initial
flows cash of 12
1I =
+8 . +
+88
<@ . ++;
= =
-ccept project if 1I 4 +.
!eject if 1I 6 +.8
). E6UI2ALENT ANNUAL ANNUIT"
Hhat do you do when project lives vary significantlyG -n
easy and intuitively appealing approach is to compare the
Mequivalent annual annuityN among all the projects. The
equivalent annuity is the level annual payment across a project?s
specific life that has a present value equal to that of another
cash'flow stream. 1rojects of equal si*e but different life can be
ranked directly by their equivalent annuity. This approach is
also known as equivalent annual cost, equivalent annual cash
flow, or simply equivalent annuity approach. The equivalent
annual annuity is solved for by this equationC
)quivalent -nnuity > 12&Cash lows( 5 &present value factor
of n'year annuity(
I2. P!7ECT DECISI!N ANAL"SIS
A.MA/ING G!8N!9G! P!7ECT DECISI!N
3Sugge#ti$n# b1 . B+une+4
2irtually all general managers face capital'budgeting
decisions in the course of their careers. The most common
of these is the simple MyesN versus MnoN choice about a
capital investment. The following are some general
guidelines to orient the decision maker in these situations.
+. ocus on cash flows, not profits. One wants to get as
close as possible to the economic reality of the project.
-ccounting profits contain many kinds of economic
fiction. lows of cash, on the other hand, are economic
facts.
,. ocus on incremental cash flows. The point of the
whole analytical e$ercise is to judge whether the firm
will be better off or worse off if it undertakes the
project. Thus one wants to focus on the changes in cash
flows effected by the project. The analysis may require
some careful thoughtC a project decision identified as a
simple go5no'go question may hide a subtle substitution
or choice among alternatives. or instance, a proposal
to invest in an automated machine should trigger many
questionsC Hill the machine e$pand capacity &and thus
permit us to e$ploit demand beyond our current limits(G
Hill the machine reduce costs &at the current level of
demand( and thus permit us to operate more efficiently
than before we had the machineG Hill the machine
create other benefits &e.g., higher quality, more
operational fle$ibility(G The key economic question
asked of project proposals should be, M#ow will things
change &i.e., be better or worse( if we undertake the
projectGN
.. -ccount for time. Time is money. He prefer to receive
cash sooner rather than later. Lse 712 as the technique
to summari*e the quantitative attractiveness of the
project. Ouite simply, 712 can be interpreted as the
amount by which the market value of the firm?s equity
will change as a result of undertaking the project.
0. -ccount for risk. 7ot all projects present the same level
or risk. One wants to be compensated with a higher
return for taking more risk. The way to control for
variations in risk from project to project is to use a
discount rate to value a flow of cash that is consistent
with the risk of that flow.
T(e#e : p+ecept# #u;;a+i<e a g+eat a;$unt $%
ec$n$;ic t(e$+1 t(at (a# #t$$d t(e te#t $% ti;e.
!+gani<ati$n# u#ing t(e#e p+ecept# ;a0e bette+ in-e#t;ent
deci#i$n# t(an $+gani<ati$n# t(at d$ n$t u#e t(e#e p+ecept#.
B. THE P!CESS !) P!7ECT E2ALUATI!N
3Sugge#ti$n# b1 . B+une+4
=. Ca+e%ull1 e#ti;ate e'pected %utu+e ca#( %l$*#.
>. Select a di#c$unt +ate c$n#i#tent *it( t(e +i#0 $% t($#e
%utu+e ca#( %l$*#.
?. C$;pute a @ba#e9ca#eA NP2.
:. Identi%1 +i#0# and unce+taintie#. un a #en#iti-it1
anal1#i#.
Identify Mkey value driversN.
Identify break'even assumptions.
)stimate scenario values.
Bon! t"e ran#e o$ %ale&
B. Identi%1 .ualitati-e i##ue#.
le$ibility
Ouality
Pnow'how
Aearning
C. Decide
C.CAPITAL ATI!NING
3Sugge#ti$n# b1 . B+une+4
)$ists whenever enterprises cannot, or choose not to,
accept all value'creating investment projects. 1ossible
causesC
%anks and investors say M7ON
=anagerial conservatism
-nalysis is required. One must consider sets of projects, or
MbundlesN, rather than individual projects. The goal should
be to identify the value'ma$imi*ing bundle of projects.
The danger is that the capital'rationing constraint heightens
the influence of nonfinancial considerations, such as the
followingC
Competition among alternative strategies
Corporate politics
%argaining games and psychology
The outcome could be a sub'optimal capital budget, or,
worse, one that destroys valueF
"ome remedies are the followingC
!ela$ and eliminate the budget constraint.
=anage the process rather than the outcomes.
/evelop a corporate culture committed to value
creation.