Capital Budgeting Basics

Capital investments are long-term investments in which the assets involved have useful lives
of multiple years. For example, constructing a new production facility and investing in
machinery and equipment are capital investments. Capital budgeting is a method of
estimating the financial viability of a capital investment over the life of the investment.
Unlike some other types of investment analysis, capital budgeting focuses on cash flows
rather than profits. Capital budgeting involves identifying the cash in flows and cash out flows
rather than accounting revenues and expenses flowing from the investment. For example,
non-expense items like debt principal payments are included in capital budgeting because
they are cash flow transactions. Conversely, non-cash expenses like depreciation are not
included in capital budgeting (except to the extent they impact tax calculations for "after tax"
cash flows) because they are not cash transactions. Instead, the cash flow expenditures
associated with the actual purchase and/or financing of a capital asset are included in the
analysis.
Over the long run, capital budgeting and conventional profit-and-loss analysis will lend to
similar net values. However, capital budgeting methods include adjustments for the time value
of money. Capital investments create cash flows that are often spread over several years into
the future. To accurately assess the value of a capital investment, the timing of the future
cash flows are taken into account and converted to the current time period (present value).
Below are the steps involved in capital budgeting.

1. Identify long-term goals of the individual or business.

2. Identify potential investment proposals for meeting the long-term goals identified in
Step 1.
3. Estimate and analyze the relevant cash flows of the investment proposal identified in
Step 2.
4. Determine financial feasibility of each of the investment proposals in Step 3 by using
the capital budgeting methods outlined below.
5. Choose the projects to implement from among the investment proposals outlined in
Step 4.
6. Implement the projects chosen in Step 5.
7. Monitor the projects implemented in Step 6 as to how they meet the capital budgeting
projections and make adjustments where needed.

There are several capital budgeting analysis methods that can be used to determine the
economic feasibility of a capital investment. They include the Payback Period, Discounted
Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified
Internal Rate of Return.

Payback Period
If the cash flows are even you have the formula:
Payback Period = Initial Investment / Net Cash Flow per period

If the cash flows are uneven you have:

Payback Period = (Years before full recovery + Unrecovered cost at the start of the year) /
Cash flow during the year

A simple method of capital budgeting is the Payback Period. It represents the amount of time
required for the cash flows generated by the investment to repay the cost of the original
investment. For example, assume that an investment of $600 will generate annual cash flows
of $100 per year for 10 years. The number of years required to recoup the investment is six
years.
The Payback Period analysis provides insight into the liquidity of the investment (length of
time until the investment funds are recovered). However, the analysis does not include cash
flow payments beyond the payback period. In the example above, the investment generates
 cash flows for an additional four years beyond the six year payback period. The value of
these four cash flows is not included in the analysis. Suppose the investment generates cash
flow payments for 15 years rather than 10. The return from the investment is much greater
because there are five more years of cash flows. However, the analysis does not take this
into account and the Payback Period is still six years.

Three capital projects are outlined in Table 1. Each requires an initial $1,000 investment. But
each project varies in the size and number of cash flows generated. Project C has the
shortest Payback Period of two years. Project B has the next shortest Payback (almost three
years) and Project A has the longest (four years). However, Project A generates the most
return ($2,500) of the three projects. Project C, with the shortest Payback Period, generates
the least return ($1,500). Thus, the Payback Period method is most useful for comparing
projects with nearly equal lives.

Advantages and Limitations of payback period

Advantages

▪ Simple and easy to understand

▪ Useful for evaluating short-term projects

▪ Provides a quick assessment of the project’s risk and liquidity

▪ Can help avoid investments that take too long to recoup their costs

▪ Does not require estimating future cash flows or discount rates

Limitations

▪ Ignores the time value of money

▪ Does not consider cash flows beyond the payback period

▪ Ignores profits earned after the payback period

▪ Ignores the risk associated with future cash flows

▪ Cannot be used to compare projects with different lifespans

Discounted Payback Period
The Payback Period analysis does not take into account the time value of money. To correct
for this deficiency, the Discounted Payback Period method was created. As shown in Figure
1, this method discounts the future cash flows back to their present value so the investment
and the stream of cash flows can be compared at the same time period. Each of the cash
flows is discounted over the number of years from the time of the cash flow payment to the
time of the original investment. For example, the first cash flow is discounted over one year
and the fifth cash flow is discounted over five years.

To properly discount a series of cash flows, a discount rate must be established. The discount
rate for a company may represent its cost of capital or the potential rate of return from an
alternative investment.

The discounted cash flows for Project B in Table 1 are shown in Table 2. Assuming a 10
percent discount rate, the $350 cash flow in year one has a present value of $318 (350/1.10)
because it is only discounted over one year. Conversely, the $350 cash flow in year five has a
present value of only $217 (350/1.10/1.10/1.10/1.10/1.10) because it is discounted over five
years. The nominal value of the stream of five years of cash flows is $1,750 but the present
value of the cash flow stream is only $1,326.
In Table 3, a Discounted Payback Period analysis is shown using the same three projects
outlined in Table 1, except the cash flows are now discounted. You can see that it takes
longer to repay the investment when the cash flows are discounted. For example, it takes
3.54 years rather than 2.86 years (.68 of a year longer) to repay the investment in Project B.
Discounting has an even larger impact for investments with a long stream of relatively small
cash flows like Project A. It takes an additional 1.37 years to repay Project A when the cash
flows are discounted. It should be noted that although Project A has the longest Discounted
Payback Period, it also has the largest discounted total return of the three projects ($1,536).

Net Present Value

The Net Present Value (NPV) method involves discounting a stream of future cash flows back
to present value. The cash flows can be either positive (cash received) or negative (cash
paid). The present value of the initial investment is its full face value because the investment
is made at the beginning of the time period. The ending cash flow includes any monetary sale
value or remaining value of the capital asset at the end of the analysis period, if any. The
cash inflows and outflows over the life of the investment are then discounted back to their
present values.
The Net Present Value is the amount by which the present value of the cash inflows exceeds
the present value of the cash outflows. Conversely, if the present value of the cash outflows
exceeds the present value of the cash inflows, the Net Present Value is negative. From a
different perspective, a positive (negative) Net Present Value means that the rate of return on
the capital investment is greater (less) than the discount rate used in the analysis.
The discount rate is an integral part of the analysis. The discount rate can represent several
different approaches for the company. For example, it may represent the cost of capital such
as the cost of borrowing money to finance the capital expenditure or the cost of using the
 company’s internal funds. It may represent the rate of return needed to attract outside
investment for the capital project. Or it may represent the rate of return the company can
receive from an alternative investment. The discount rate may also reflect the Threshold Rate
of Return (TRR) required by the company before it will move forward with a capital
investment. The Threshold Rate of Return may represent an acceptable rate of return above
the cost of capital to entice the company to make the investment. It may reflect the risk level
of the capital investment. Or it may reflect other factors important to the company. Choosing
the proper discount rate is important for an accurate Net Present Value analysis.

A simple example using two discount rates is shown in Table 4. If the five percent discount
rate is used, the Net Present Value is positive and the project is accepted. If the 10 percent
rate is used, the Net Present Value is negative and the project is rejected.

Advantages and Limitations of NPV

Advantages

▪ Considers the time value of money

▪ Accounts for all expected cash inflows and outflows

▪ Provides a measure of the investment’s profitability

▪ Can be used to compare multiple investment opportunities

Limitations

▪ Requires accurate estimates of future cash flows and discount rates

▪ Can be complex and time-consuming to calculate

▪ Does not consider non-financial factors such as environmental impact or social responsibility.
Profitability Index
Another measure to determine the acceptability of a capital investment is the Profitability
Index (PI). The Profitability Index is computed by dividing the present value of cash inflows of
the capital investment by the present value of cash outflows of the capital investment. If the
Profitability Index is greater than one, the capital investment is accepted. If it is less than one,
the capital investment is rejected.

A Profitability Index analysis is shown with two discount rates (5% and 10%) in Table 5. The
Profitability Index is positive (greater than one) with the five percent discount rate. The
Profitability Index is negative (less than one) with 10% discount rate. If the Profitability Index
is greater than one, the investment is accepted. If it is less than one, it is rejected.
The Profitability Index is a variation of the Net Present Value approach to comparing projects.
Although the Profitability Index does not stipulate the amount of cash return from a capital
investment, it does provide the cash return per dollar invested. The index can be thought of
as the discounted cash inflow per dollar of discounted cash outflow. For example, the index at
the five percent discount rate returns $1.10 of discounted cash inflow per dollar of discounted
cash outflow. The index at the 10% discount rate returns only 94.5 cents of discounted cash
inflow per dollar of discounted cash outflow. Because it is an analysis of the ratio of cash
inflow per unit of cash outflow, the Profitability Index is useful for comparing two or more
projects which have very different magnitudes of cash flows.
 Internal Rate of Return
Another method of analyzing capital investments is the Internal Rate of Return (IRR). The
Internal Rate of Return is the rate of return from the capital investment. In other words, the
Internal Rate of Return is the discount rate that makes the Net Present Value equal to zero.
As with the Net Present Value analysis, the Internal Rate of Return can be compared to a
Threshold Rate of Return to determine if the investment should move forward.
An Internal Rate of Return analysis for two investments is shown in Table 6. The Internal Rate
of Return of Project A is 7.9%. If the Internal Rate of Return (e.g. 7.9%) is above the
Threshold Rate of Return (e.g. 7%), the capital investment is accepted. If the Internal Rate of
Return (e.g. 7.9%) is below the Threshold Rate of Return (e.g. 9%), the capital investment is
rejected. However, if the company is choosing between projects, Project B will be chosen
because it has a higher Internal Rate of Return.

The Internal Rate of Return analysis is commonly used in business analysis. However, a
precaution should be noted. It involves the cash surpluses/deficits during the analysis period.
As long as the initial investment is a cash outflow and the trailing cash flows are all inflows,
the Internal Rate of Return method is accurate. However, if the trailing cash flows fluctuate
between positive and negative cash flows, the possibility exists that multiple Internal Rates of
Return may be computed.

Advantages and Limitations of IRR

Advantages

▪ Considers the time value of money

▪ Accounts for all expected cash inflows and outflows

▪ Provides a measure of the investment’s profitability

▪ Can be used to compare multiple investment opportunities

Limitations

▪ Requires accurate estimates of future cash flows and discount rates

▪ May lead to incorrect decisions when evaluating mutually exclusive projects

▪ May result in multiple IRR values for some projects

Modified Internal Rate of Return

Another problem with the Internal Rate of Return method is that it assumes that cash flows
during the analysis period will be reinvested at the Internal Rate of Return. If the Internal Rate
of Return is substantially different than the rate at which the cash flows can be reinvested, the
results will be skewed.

To understand this we must further investigate the process by which a series of cash flows
are discounted to their present value. As an example, the third year cash flow in Figure 2 is
shown discounted to the current time period.

However, to accurately discount a future cash flow, it must be analyzed over the entire five
year time period. So, as shown in Figure 3, the cash flow received in year three must be
compounded for two years to a future value for the fifth year and then discounted over the
entire five-year period back to the present time. If the interest rate stays the same over the
compounding and discounting years, the compounding from year three to year five is offset by
the discounting from year five to year three. So, only the discounting from year three to the
present time is relevant for the analysis (Figure 2).
For the Discounted Payback Period and the Net Present Value analysis, the discount rate
(the rate at which debt can be repaid or the potential rate of return received from an
alternative investment) is used for both the compounding and discounting analysis. So only
the discounting from the time of the cash flow to the present time is relevant.
However, the Internal Rate of Return analysis involves compounding the cash flows at the
Internal Rate of Return. If the Internal Rate of Return is high, the company may not be able to
reinvest the cash flows at this level. Conversely, if the Internal Rate of Return is low, the
company may be able to reinvest at a higher rate of return. So, a Reinvestment Rate of
Return (RRR) needs to be used in the compounding period (the rate at which debt can be
repaid or the rate of return received from an alternative investment). The Internal Rate of
Return is then the rate used to discount the compounded value in year five back to the
present time.

The Modified Internal Rate of Return for two $10,000 investments with annual cash flows of
$2,500 and $3,000 is shown in Table 7. The Internal Rates of Return for the projects are 7.9%
and 15.2%, respectively. However, if we modify the analysis where cash flows are reinvested
at 7%, the Modified Internal Rates of Return of the two projects drop to 7.5% and 11.5%,
respectively. If we further modify the analysis where cash flows are reinvested at 9%, the first
 Modified Internal Rate of Return rises to 8.4% and the second only drops to 12.4%. If the
Reinvestment Rate of Return is lower than the Internal Rate of Return, the Modified Internal
Rate of Return will be lower than the Internal Rate of Return. The opposite occurs if the
Reinvestment Rate of Return is higher than the Internal Rate of Return. In this case the
Modified Internal Rate of Return will be higher than the Internal Rate of Return.

Advantages and Limitations of MIRR

Advantages

▪ Considers the reinvestment of future cash flows

▪ Accounts for the time value of money

▪ Provides a measure of the investment’s profitability

Limitations

▪ Requires accurate estimates of future cash flows and reinvestment rates

▪ Can be complex and time-consuming to calculate

▪ May not be appropriate for investments with uneven cash flows

Comparison of Methods
For a comparison of the six capital budgeting methods, two capital investments projects are
presented in Table 8 for analysis. The first is a $300,000 investment that returns $100,000 per
 year for five years. The other is a $2 million investment that returns $600,000 per year for five
years.
Both projects have Payback Periods well within the five year time period. Project A has the
shortest Payback Period of three years and Project B is only slightly longer. When the cash
flows are discounted (10%) to compute a Discounted Payback Period, the time period needed
to repay the investment is longer. Project B now has a repayment period over four years in
length and comes close to consuming the entire cash flows from the five year time period.
The Net Present Value of Project B is $275,000 compared to only $79,000 for Project A. If
only one investment project will be chosen and funds are unlimited, Project B is the preferred
investment because it will increase the value of the company by $275,000.
However, Project A provides more return per dollar of investment as shown with the
Profitability Index ($1.26 for Project A versus $1.14 for Project B). So if funds are limited,
Project A will be chosen.
Both projects have a high Internal Rate of Return (Project A has the highest). If only one
capital project is accepted, it’s Project A. Alternatively, the company may accept projects
based on a Threshold Rate of Return. This may involve accepting both or neither of the
projects depending on the size of the Threshold Rate of Return.
When the Modified Internal Rates of Return are computed, both rates of return are lower than
their corresponding Internal Rates of Return. However, the rates are above the Reinvestment
Rate of Return of 10%. As with the Internal Rate of Return, the Project with the higher
Modified Internal Rate of Return will be selected if only one project is accepted. Or the
modified rates may be compared to the company’s Threshold Rate of Return to determine
which projects will be accepted.

SIGNIFICANCE OF CAPITAL BUDGETING

●Capital budgeting is an essential tool in financial management

●Capital budgeting provides a wide scope for financial managers to evaluate different projects
in terms of their viability to be taken up for investments

●It helps in exposing the risk and uncertainty of different projects

●It helps in keeping a check on over or under investments

●The management is provided with an effective control on cost of capital expenditure projects

●Ultimately the fate of a business is decided on how optimally the available resources are used

Conclusion
Each of the capital budgeting methods outlined has advantages and disadvantages. The
Payback Period is simple and shows the liquidity of the investment. But it doesn’t account for
the time value of money or the value of cash flows received after the payback period. The
Discounted Payback Period incorporates the time value of money but still doesn’t account for
cash flows received after the payback period. The Net Present Value analysis provides a
dollar denominated present value return from the investment.
However, it has little value for comparing investments of different size. The Profitability Index
is a variation on the Net Present Value analysis that shows the cash return per dollar
invested, which is valuable for comparing projects. However, many analysts prefer to see a
percentage return on an investment. For this the Internal Rate of Return can be computed.
But the company may not be able to reinvest the internal cash flows at the Internal Rate of
Return. Therefore, the Modified Internal Rate of Return analysis may be used.
Which capital budgeting method should you use? Each one has unique advantages and
disadvantages, and companies often use all of them. Each one provides a different
perspective on the capital investment decision.