Sunil Kumar Injeti

Amit Kumar

What.

Summary of the Article

Capital Budgeting Theory

Survey Results

Gaps between Theory and Practice

Reasons for Gaps

Revisiting Summary and Implications

Summary of the Article

Many capital budgeting practices differ from what the relevant theory
prescribes, this is evident from the survey done in a four-stage framework
for the capital budgeting process.

Four Stage Capital Budgeting model

1.

Identification of an investment opportunity

2.

Selection of a project

3.

Development

4.

Control, including post-audit, assess forecast accuracy.

Capital Budgeting Theory

What is Capital Budgeting ?

The process through which different projects are evaluated is known as

capital budgeting

Capital budgeting is the firms formal process for the acquisition and
investment of capital. It involves firms decisions to invest its current funds
for addition, disposition, modification and replacement of fixed assets.

Capital budgeting is long term planning for making and

proposed capital outlays- Charles T Horngreen.

financing

Capital Budgeting Techniques

Pay Back
- How many years to recover initial cost

Net Present Value (NPV)

- Present value of inflows less outflows

Internal Rate of Return

- Projects return on investment

Profitability Index
- Ratio of present value of inflows to outflows

Capital Budgeting Techniques - Payback

Period

Payback period is the time it takes to recover early cash outflows

o

Shorter payback periods are better

Payback Decision Rules

o

Stand-alone projects

Mutually Exclusive Projects

payback period < policy maximum accept

Payback period > policy maximum reject
If PaybackA < PaybackB choose Project A

Weaknesses of the Payback Method

o
o

Ignores time value of money

Ignores cash flows after payback period

Capital Budgeting Techniques - Net Present

Value (NPV)

Difference between present value of expected future benefits of project to present value of
expected cost of project

NPV = PVB PVC

Where PVB = present value of benefits
PVC = present value of costs

Decision Rules

Stand-alone Projects
NPV > 0 accept
NPV < 0 reject

Mutually Exclusive Projects

NPVA > NPVB choose Project A over B

Capital Budgeting Techniques - Internal

Rate of Return (IRR)

Discount rate that exactly equates present value of

expected benefits to cost (drives NPV to zero)

Find this discount rate by trial and error

Ex.:

Use discount rate of 20% as first estimate of IRR on Project A.

NPVa = PVBa PVCa
NPVa = $40,040
Since NPV is too high, use higher estimate of 40%.
NPVa = $1,240
Use estimate of 41% to get closer to zero.
NPVa = $290

Capital Budgeting Techniques - Profitability

Index (PI)

Meaning: PI is the ratio of the present value of the future free cash flows
(FCF) to the initial outlay. It yields the same accept/reject decision as NPV

Decision Rule:

PI 1 = accept;
PI < 1 = reject

Survey Results

Gaps between Capital Budgeting Theory

and Practice
1.

The use of discounted cash flow techniques is now the rule rather than the
exception, but it is internal rate of return (IRR), not the theoretically preferable
net present value (NPV) technique, that business has chosen as its method.

2.

Despite many years of disparagement, payback period is still widely used.

3.

The theoretical prescription for capital rationing, optimization under capital

constraints, linear programming is infrequently used.

4.

Though most firms use the cost of capital, a significant minority do not use it
exactly as it is suggested by theory.

5.

Risk analysis models are yet to be accepted universally. Many firms simply
change the required payback period to adjust for risk.

Reasons for the Gaps between Theory and

Practice
Review of the related literature leads us to believe that much of the gap can be
attributed to deficiencies in the theory itself. The limitations of the theoretical
models include
1.

An inability to capture the role of the organizational structure and behavior in

corporate decision making.

2.

A failure to incorporate management behavior toward risk.

3.

Difficulties in application due especially to unrealistic assumptions about data

availability.

4.

Inability to incorporate strategic considerations in decisions made by the firm.

Revisiting Summary and Implications

1.

Several inconsistencies exist between the pertinent theory and practice.

2.

These inconsistencies are more evident in selection stage.

3.

Main reason for these differences can be attributed to deficiencies in the theory itself.

4.

Future work in capital budgeting should consider organizational behavior thus making it
more than just calculating cost of capital and project NPV.

5.

Future surveys should include all four stages of capital budgeting process & broaden their
scope to explore why businesses did not accept proposed theories.

6.

Academia should propose theories which are valuable to both business & academia

Questions

Appendix

Capital Budgeting Techniques Payback

Period

Poor method on which to rely for allocation of scarce capital resources because:
1.

Payback ignores time value of money

2.

Payback ignores expected cash flows beyond payback period.

PROJECT A
Cost = $100,000
Expected Future Cash Flow:
Year 1
$50,000
Year 2
$50,000
Year 3
$110,000
Year 4 and thereafter: None
Total = $210,000
Payback = 2 years

PROJECT B
Cost = $100,000
Expected Future Cash Flow:
Year 1
$100,000
Year 2
$5,000
Year 3
$5,000
Year 4 and thereafter: None
Total = $110,000
Payback = 1 year

-Payback period for Project B is shorter, but Project A provides higher return
-Though Project A is superior to Project B, Project B is preferred over A as per
payback period criteria.

IRR vs NPV

The NPV method is inherently complex and requires assumptions at each

stage - discount rate, likelihood of receiving the cash payment, etc. The IRR
method simplifies projects to a single number that management can use to
determine whether or not a project is economically viable.

The result is simple, but for any project that is long-term, that has multiple
cash flows at different discount rates, or that has uncertain cash flows - in
fact, for almost any project at all - simple IRR isn't good for much more than
presentation value.