Chapter 22
Capital budgeting
To select the best long-term investments, firms rely on a process called ‘capital budgeting’. There is typically a lot of uncertainty around major investments, and the techniques of capital budgeting are a useful way of reducing that uncertainty and clarifying the likely returns on the investment. There are several different techniques, each with their own pros and cons.
When to use it
- To decide whether a firm should make a capital investment.
- To evaluate the relative attractiveness of several potential projects.
Origins
Capital budgeting as a tool has been around at least since humans began farming. Historian Fritz Heichelheim believed that capital budgeting was employed in food production by about 5,000 BC. He noted that:
Dates, olives, figs, nuts, or seeds of grain were probably lent out . . . to serfs, poorer farmers, and dependents, to be sown and planted, and naturally an increased portion of the harvest had to be returned in kind (and) animals could be borrowed too for a fixed time limit, the loan being repaid according to a fixed percentage from the young animals born subsequently.
The first documented interest rates in history – likely used as discount rates – are from Bronze-Age Mesopotamia, where rates of one shekel per month for each mina owed (or 1/60th) were levied – a rate of 20 per cent per annum.
Capital budgeting techniques have obviously become more sophisticated over the years, but they are still based on simple ‘time-value of money’ principles.
What it is
Firms commit to significant capital expenditures, such as buying or refurbishing equipment, building a new factory, or buying real estate with the goal of expanding the number of stores under a banner. The large amounts spent for these types of projects are known as capital expenditures (to distinguish them from day-to-day costs, which are called operating expenditures).
The underlying logic of capital budgeting is very straightforward: it involves estimating all the future cash flows (in and out) for the specific project under consideration, and then discounting all these cash flows back to the present to figure out how profitable the project is.
There are three main capital-budgeting techniques employed by firms:
- Payback period: The length of time it will take for the project to pay for itself.
- Net present value (NPV): The net value of all future cash flows associated with the project, discounted to the present day.
- Internal rate of return (IRR): The rate of return, as a percentage, that gives a project a net present value of zero.
It should be clear that these are all variations on the same theme. We explain below how each of them is used. From a theoretical perspective, NPV is the best approach. However, many firms use IRR and payback period because they are intuitively attractive and easy to understand.
How to use it
The three capital-budgeting decision rules have slightly different qualities, and the best way to understand their pros and cons is to work through an example. Let’s say a manager needs to decide whether to refurbish his factory’s machines or buy new ones. Refurbishing (for $100,000) costs less than buying new machines (for $200,000), but buying new delivers a higher stream of cash flows.
Payback period
Here is the comparison over a five-year period:
| Period | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| Refurbish | (100,000) | 50,000 | 50,000 | 30,000 | 20,000 | 10,000 |
| Buy new | (200,000) | 30,000 | 100,000 | 70,000 | 70,000 | 70,000 |
If you were to use payback period as the decision rule, you can see that the manager should choose to refurbish the machines because the investment will have a payback period of two years. For the new machines, the payback is three years. While payback is not the most refined technique for evaluating capital investments, it can be effective because it is simple and quick to calculate.
Net present value (NPV)
Let’s assume that the business has a discount rate of 10 per cent. Using the NPV method, you can calculate a discount factor for each period and discount the cash flows by the corresponding factor:
| Period | 0 | 1 | 2 | 3 | 4 | 5 | NPV |
|---|---|---|---|---|---|---|---|
| Refurbish | (100,000) | 45,455 | 41,322 | 22,539 | 13,660 | 6,209 | 29,186 |
| Buy new | (200,000) | 27,273 | 82,645 | 52,592 | 47,811 | 43,464 | 53,785 |
| Discount factor | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
The net present value is the sum of the investment and all future cash flows, discounted at 10 per cent. This NPV analysis shows that the manager should buy new machines because the investment delivers, over a five-year period, a higher net present value. This also shows how a payback analysis can fall short: it does not take into account future cash flows and it does not consider a discount rate.
Internal rate of return (IRR)
The internal rate of return finds the discount rate for the streams of cash flows, assuming the net present value is set to zero. The notion of IRR is attractive because it is easy to calculate and delivers one single number. Here is the IRR calculation for the example we’ve been using:
| Period | 0 | 1 | 2 | 3 | 4 | 5 | IRR |
|---|---|---|---|---|---|---|---|
| Refurbish | (100,000) | 50,000 | 50,000 | 30,000 | 20,000 | 10,000 | 24% |
| Buy new | (200,000) | 30,000 | 100,000 | 70,000 | 70,000 | 70,000 | 19% |
In contrast with the NPV method, the use of IRR suggests that the manager should refurbish the machines. Can two methods more sophisticated than payback period deliver different results?
Yes, because of the timing of cash flows. Notice that the bulk of the cash inflows happen in year three and beyond, and these delayed cash flows are penalised at a higher rate. In the ‘refurbish’ example, the biggest cash inflows occur in years 1 and 2. Here is what happens if you reverse the stream of cash flows – year 1 with year 5 and year 2 with year 4 – without altering the total amounts:
| Period | 0 | 1 | 2 | 3 | 4 | 5 | IRR |
|---|---|---|---|---|---|---|---|
| Refurbish | (100,000) | 10,000 | 20,000 | 30,000 | 50,000 | 50,000 | 14% |
| Buy new | (200,000) | 70,000 | 70,000 | 70,000 | 100,000 | 30,000 | 22% |
You can see that the IRR analysis now suggests that ‘buy new’ is the way to go. For perspective, the NPV analysis – using the reversed stream of cash flows – continues to suggest ‘buy new’ as the best option (discount rate 10 per cent):
| Period | 0 | 1 | 2 | 3 | 4 | 5 | NPV |
|---|---|---|---|---|---|---|---|
| Refurbish | (100,000) | 9,091 | 16,529 | 22,539 | 34,151 | 31,046 | 13,356 |
| Buy new | (200,000) | 63,636 | 57,851 | 52,592 | 68,301 | 18,628 | 61,009 |
| Discount factor | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
Top practical tip
Of the three techniques, payback period is the least accurate and should not be used unless there are other reasons why getting your money back quickly is important.
Of the other two, NPV is technically more accurate, while IRR is attractive because it provides a single, intuitively meaningful number for a given project. But, as you can see from the examples above, it is helpful to look at various techniques in order to understand how sensitive their assumptions can be.
Top pitfall
Keep in mind that cash flows are not usually invested at the same rate. Both NPV and IRR assume that any cash flows received are reinvested at the same rate. So, the first of the two IRR analyses presumes that the cash flows are reinvested and compounded at a rate of 24 per cent for each of the remaining years. In practice, cash flows received may not be reinvested at the same rate because they are used to pay off loans and other expenses, or they are invested in other projects (which may not promise the same returns).
Further reading
Berk, J. and DeMarzo, P. (2013) Corporate Finance: The Core, 3rd edition. Harlow, UK: Pearson.
Heichelheim, F.M. and Stevens, J. (1958) An Ancient Economic History: From the Palaeolithic age to the migrations of the Germanic, Slavic and Arabic nations, Vol. 1. Browse online at www.questia.com