Capital Budgeting Summary

Capital budgeting is the process of evaluating a company’s potential investments and deciding which ones to accept. A company’s market value added (MVA) is the sum of all its projects’ net present values (NPVs). Basically, one can calculate the free cash flows (FCFs) for a project in much the same way as for a firm. When a project’s free cash flows are discounted at the appropriate risk-adjusted rate, the result is the project’s value. One difference between valuing a firm and a project is the rate that is used to discount cash flows. For a firm, it is the overall weighted cost of capital, while for a project, it is r, the project’s risk adjusted cost of capital. Subtracting the initial cost of a project gives the NPV of the project. If a project has a positive NPV, then it adds value to the firm. In this chapter, an overview of the capital budgeting and the basic techniques used to evaluate potential projects, are discussed.

Overview of Capital Budgeting

Capital budgeting is the decision process that managers use to identify projects that add to the firm’s value, and as such it is perhaps the most important task faced by financial managers and their staffs. It is important because of the following reasons:

1) A company’s capital budgeting decisions define its strategic direction. The reason is that moves into new products, services, or markets must be preceded by capital expenditures;

2) Results of capital budgeting decisions usually continue for many years, reducing the flexibility of decisions;

3) Poor capital budgeting can have serious financial consequences. For example, if a company invests too much, it will waste investors’ capital on excess capacity. On the other hand, if it does not invest enough, its equipment and computer software may not be sufficiently modern to enable it to produce competitively. In addition, inadequate capacity may cause the company to lose market share to rival companies, and regaining lost customers requires heavy selling expenses, price reductions, or product improvements, all of which are costly.

It is generally agreed that, a company’s grow, and even its ability to remain competitive and to survive, depends on a constant flow of ideas for new products, for ways to make existing products better, and for ways to operate at a lower cost. Accordingly, a well-managed company will go to great lengths to encourage good capital budgeting proposals from its employees. If a company has capable and imaginative executives and employees, and if its incentive system is working properly, many ideas for capital investment will be advanced. Some ideas may be good, but others will not. Therefore, companies must use some techniques to screen projects for their values, which are discussed below.

Project Classifications

Companies generally categorize projects and then analyze those in each category somewhat differently to understand their values. Those categories are:

1) Replacement: maintenance of business;

2) Replacement: cost reduction;

3) Expansion of existing products or markets;

4) Expansion into new products or markets;

5) Safety and/or environmental projects;

6) Research and development; and,

7) Long-term contracts.

With each category, projects are classified by their dollar costs, i.e., larger investments require increasingly detailed analysis and approval at a higher level within the company.

Capital Budgeting Decision Rules

There are six key methods that are frequently used to evaluate projects and to decide whether or not they should be accepted for inclusion in the capital budget, which are, payback, discounted payback, net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index (PI). Details of the six methods are shown below. To make explanations easier, one example as shown in Figure 1 will be used. Figure 1 shows the expected cash flows for two projects, S and L. The two projects are assumed to be equally risky, and the cash flows for each year, CFt, reflect purchase cost, investments in working capital, taxes, depreciation, and salvage values. It is also assumed that all cash flows occur at the end of the designated year. As the numbers show, project S is a short-term project comparing with project L in the sense that its cash inflows come in sooner than project L’s.

Figure 1: Net Cash Flows for