Capital Budgeting

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 (Cabrera, 2011). CAPITAL IS A LIMITED RESOURCE 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 Federal Reserve System requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers.

But even if a bank were to extend 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. Even 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.

http://www.studyfinance.com/ Importance of Capital Budgeting Capital budgeting is a step by step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company's growth initiatives, involves determining the investment rate of return that such a project will generate. However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project. For example, a social or charitable project is often not approved based on rate of return, but more on the desire of a business to foster goodwill

and

contribute

back

to

its

community.

Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive

marketplace.

Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project. Capital budgeting is also vital to a business because it creates a structured step by step process

that

enables

a

company

to:

1. Develop and formulate long-term strategic goals – the ability to set long-term goals is essential to the growth and prosperity of any business. The ability to appraise/value investment projects via capital budgeting creates a framework for businesses

to

plan

out

future

long-term

direction.

2. Seek out new investment projects – knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry. 3. Estimate and forecast future cash flows – future cash flows are what create value for businesses overtime. Capital budgeting enables executives to take a potential project and estimate its future cash flows, which then helps determine if such a project

should

be

accepted.

4. Facilitate the transfer of information – from the time that a project starts off as an idea to the time it is accepted or rejected, numerous decisions have to be made at various levels of authority. The capital budgeting process facilitates the transfer of information to the appropriate decision makers within a company. 5. Monitoring and Control of Expenditures – by definition a budget carefully identifies the necessary expenditures and R&D required for an investment project. Since a good project can turn bad if expenditures aren't carefully controlled or monitored, this step is a crucial benefit of the capital budgeting process. 6. Creation of Decision – when a capital budgeting process is in place, a company is then able to create a set of decision rules that can categorize which projects are acceptable and which projects are unacceptable. The result is a more efficiently run business that is better equipped to quickly ascertain whether or not to proceed further with a project or shut it down early in the process, thereby saving a company both time and money. Unlike other business decisions that involve a singular aspect of a business, a capital budgeting decision involves two important decisions at once: a financial decision and an investment decision. By taking on a project, the business has agreed to make a financial commitment to a project, and that involves its own set of risks. Projects can run into delays, cost overruns and regulatory restrictions that can all delay or increase the projected

cost

of

the

project.

In addition to a financial decision, a company is also making an investment in its future

direction and growth that will likely have an influence on future projects that the company considers and evaluates. So to make a capital investment decision only from the perspective of either a financial or investment decisions can pose serious limitations on the

success

of

the

project.

In December 2009 ExxonMobil, the world's largest oil company, announced that it was acquiring XTO Resources, one of the largest natural gas companies in the U.S. for $41 billion. That acquisition was a capital budgeting decision, one in which ExxonMobil made a huge financial commitment. But in addition, ExxonMobil was making a significant investment decision in natural gas and essentially positioning the company to also focus on growth opportunities in the natural gas arena. That acquisition alone will have a profound effect on future projects that ExxonMobil considers and evaluates for many years

to

come.

The significance of these dual decisions is profound for companies. Executives have been known to lose jobs over poor investment decisions. One can say that running a business is nothing more than a constant exercise in capital budgeting decisions. Understanding that both a financial and investment decision is being made is paramount to making successful capital investment decisions (http://www.investopedia.com/university/capitalbudgeting/importance).

The Administrative Process in Capital Budgeting The administrative process in capital budgeting refers to the framework of planning and control measures which identifies and interrelates the essential requirement s for an effective capital expenditure program. It consists of the following steps: Proposal Generation. Management encourages all levels with an organization to make suggestions for capital expenditures. Minor proposals are often reviewed at the next organizational level while major ones go to higher levels. Gathering of Relevant Data on Proposal Submitted. This is undertaken for proposals where additional data are needed before they can be objectively evaluated.

Evaluation. Capital expenditure proposals, especially the major ones are reviewed to determine whether they are appropriate or not and the economic benefits that may be derived therefrom. Cost-benefit analysis is applied by comparing the different cash flows involved. Approval and Implementation. Approval for capital expenditures is done at different levels depending on the materiality thereof. In some organizations, managers are given full authority to decide on expenditures required for continuous operations. After being approved and funding has been made available, capital expenditures are made and the projects so approved are made operational. Control of Expenditures and Follow-Up. Actual costs are recorded, reported and compared with budgeted figures so that in case there are deviations, prompt corrective measures can be adapted. (Mejorada, 2006)

Capital budgeting versus current expenditures A capital investment project can be distinguished from current expenditures by two features: a)

such

projects

are

relatively

large

b) a significant period of time (more than one year) elapses between the investment outlay and the receipt of the benefits.. As a result, most medium-sized and large organizations have developed special procedures and methods for dealing with these decisions. A systematic approach to capital budgeting implies: a) the formulation of long-term goals b) the creative search for and identification of new investment opportunities c) classification of projects and recognition of economically and/or statistically dependent proposals

d) the estimation and forecasting of current and future cash flows e) a suitable administrative framework capable of transferring the required information to the decision level f) the controlling of expenditures and careful monitoring of crucial aspects of project execution g) a set of decision rules which can differentiate acceptable from unacceptable alternatives is required.

Characteristics of a Capital Investment Decisions Capital expenditures are long-term commitments of resources to realize future benefits and budgeting for them is one of the most important areas of managerial decisions. They deserve penetrating analysis and attention of top management because of the following reasons: 1. Substantial amount of funds are required in capital projects. 2. Because of the length of tie spanned by a capital investment decisions, the element of uncertainty becomes more critical 3. The effect of managerial errors will be difficult to reverse. 4. Plans must be made well into an uncertain future. 5. Success or failure of the company may depend upon single or relatively few investment decisions. One of the most difficult steps involved in the decision-making process relates to the identification of costs relevant to the problem. Because the alternatives lie in the future, the only costs which are relevant are future costs. Historical costs arising from past decisions are sunk costs and so cannot affect future alternatives. Such considerations as monetary advantage of an alternative, its effect on employee relations, company image and relations with other companies are usually evaluated in choosing from among the alternatives (Cabrera,2011). Categories of Capital Investments The two general types of capital investment decisions are: 1. Independent Capital Investment Projects or Screening Decisions

2. Mutually Exclusive Capital Investment or Preference decisions There are three general methods for deciding which proposed projects should be ranked higher than other projects, which are (in declining order of preference): 1. Throughput

analysis.

Determines

the

impact

of

an

investment

on

the throughput of an entire system. 2. Discounted cash flow analysis. Uses a discount rate to determine the present value of all cash flows related to a proposed project. Tends to create improvements on a localized basis, rather than for the entire system, and is subject to incorrect results if cash flow forecasts are incorrect. 3. Payback analysis. Calculates how fast you can earn back your investment; is more of a measure of risk reduction than of return on investment. Throughput Analysis Under throughput analysis, the key concept is that an entire company acts as a single system, which generates a profit. Under this concept, capital budgeting revolves around the following logic: 1. Nearly all of the costs of the production system do not vary with individual sales; that is, nearly every cost is an operating expense; therefore, 2. You need to maximize the throughput of the entire system in order to pay for the operating expense; and 3. The only way to increase throughput is to maximize the throughput passing through the bottleneck operation. Consequently, you should give primary consideration to those capital budgeting proposals that favorably impact the throughput passing through the bottleneck operation. This does not mean that all other capital budgeting proposals will be rejected, since there are a multitude of possible investments that can reduce costs elsewhere in a company, and which are therefore worthy of consideration. However, throughput is more important than cost reduction, since throughput has no theoretical upper limit, whereas costs can only be reduced to zero. Given the greater ultimate impact on profits of throughput over cost reduction, any non-bottleneck proposal is simply not as important.

Discounted Cash Flow Analysis Any capital investment involves an initial cash outflow to pay for it, followed by a mix of cash inflows in the form of revenue, or a decline in existing cash flows that are caused by expense reductions. We can lay out this information in a spreadsheet to show all expected cash flows over the useful life of an investment, and then apply a discount rate that reduces the cash flows to what they would be worth at the present date. This calculation is known as net present value. Net present value is the traditional approach to evaluating capital proposals, since it is based on a single factor – cash flows – that can be used to judge any proposal arriving from anywhere in a company. For example, ABC Company is planning to acquire an asset that it expects will yield positive cash flows for the next five years. Its cost of capital is 10%, which it uses as the discount rate to construct the net present value of the project. The following table shows the calculation: Year

Cash Flow

10% Discount Factor

Present Value

0

-$500,000

1.0000

-$500,000

1

+130,000

0.9091

+118,183

2

+130,000

0.8265

+107,445

3

+130,000

0.7513

+97,669

4

+130,000

0.6830

+88,790

5

+130,000

0.6209

+80,717

Net Present Value

-$7,196

The net present value of the proposed project is negative at the 10% discount rate, so ABC should not invest in the project. In the “10% Discount Factor” column, the factor becomes smaller for periods further in the future, because the discounted value of cash flows are reduced as they progress further from the present day. The discount factor can be derived from the following formula: Present value of a

Future cash flow

future cash flow

----------------------------------------------------------------------------

=

(1 + Discount rate)squared by the number of periods of discounting Payback Analysis The simplest and least accurate evaluation technique is the payback method. This approach is still heavily used, because it provides a very fast “back of the envelope” calculation of how soon a company will earn back its investment. This means that it provides a rough measure of how long a company will have its investment at risk, before earning back the original amount expended. Thus, it is a rough measure of risk. There are two ways to calculate the payback period, which are: 1. Simplified. Divide the total amount of an investment by the average resulting cash flow. This approach can yield an incorrect assessment, because a proposal with cash flows skewed far into the future can yield a payback period that differs substantially from when actual payback occurs. 2. Manual calculation. Manually deduct the forecasted positive cash flows from the initial investment amount, from Year 1 forward, until the investment is paid back. This method is slower to calculate, but ensures a higher degree of accuracy. For example, ABC Company has received a proposal from a manager, asking to spend $1,500,000 on equipment that will result in cash inflows in accordance with the following table: Year 1 2 3 4 5

Cash Flow +$150,000 +150,000 +200,000 +600,000 +900,000

The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct.

Instead, the cost accountant runs the calculation year by year, deducting the cash flows in each successive year from the remaining investment. The results of this calculation are: Year 0 1 2 3 4 5

Cash Flow +$150,000 +150,000 +200,000 +600,000 +900,000

Net Invested Cash -$1,500,000 -1,350,000 -1,200,000 -1,000,000 -400,000 0

The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5. The cost accountant assumes the same monthly amount of cash flow in Year 5, which means that he can estimate final payback as being just short of 4.5 years. The payback method is not overly accurate, does not provide any estimate of how profitable a project may be, and does not take account of the time value of money. Nonetheless, its extreme simplicity makes it a perennial favorite in many companies( http://www.accountingtools.com/overview-of-capital-budgeting)

Capital budgeting also refers to the process we use to make decisions concerning investments in the long term assets of the firm. The general idea is that the capital, or long-term funds, raised by the firms are used to invest in assets that will enable the firm to generate revenues several years into the future. Often the funds raised to invest in such assets are not unrestricted, or infinitely available; thus the firm must budget how these funds are invested. Importance of Capital Budgeting—because capital budgeting decisions impact the firm for several years, they must be carefully planned. A bad decision can have a significant effect on the firm’s future operations. In addition, the timing of the decisions is important. Many capital budgeting projects take years to implement. If firms do not plan accordingly, they might find that the timing of the capital budgeting decision is too late, thus costly with respect to competition. Decisions that are made too early can also be problematic because capital budgeting projects generally are very large investments, thus early decisions might generate unnecessary costs for the firm. Generating Ideas for Capital Budgeting—ideas for capital budgeting projects usually are generated by employees, customers, suppliers, and so forth, and are based on the needs and experiences of the firm and of these groups. For example, a sales representative might continue to hear from some of his or her customers that there is a need for products with particular characteristics that the firm’s existing products do not possess. The sales representative presents the idea to management, who in turn evaluates the viability of the idea by consulting with engineers, production personnel, and perhaps by conducting a feasibility study. After the idea is confirmed to be viable in the sense it is saleable to customers, the financial manager must conduct a capital budgeting analysis to ensure the project will be beneficial to the firm with respect to its value. Project Classifications—capital budgeting projects usually are classified using the following terms: 

Replacement decision—a decision concerning whether an existing asset should replaced by a newer version of the same machine or even a different type of machine that does the same thing as the existing machine. Such replacements are generally made to maintain existing levels of operations, although profitability

might change due to changes in expenses (that is, the new machine might be either more expensive or cheaper to operate than the existing machine). 

Expansion decision—a decision concerning whether the firm should increase operations by adding new products, additional machines, and so forth. Such decisions would expand operations.



Independent project—the acceptance of an independent project does not affect the acceptance of any other project—that is, the project does not affect other projects. For example, if you have a large sum of money in the bank that you would like to spend on yourself, say, $150,000. You decide you are going to buy a car that costs about $30,000 and a new stereo system for your house that costs less than $5,000. The decision to buy the car does not affect the decision to buy the stereo—they are independent decisions.



Mutually exclusive projects—in this case, the decision to invest in one project affects other projects because only one project can be purchased. For example, if in the above example you decided you were going to buy only one automobile, but you were looking at two different types of cars, one is a Chevrolet and the other is a Ford. Once you make the decision to buy the Chevrolet, you have also decided you are not going to buy the Ford.

Similarities Between Capital Budgeting and Asset Valuation—to make a capital budgeting decision, we need to compare the cost of the project to the value the project will provide the firm. To determine the value of an asset, we need to compute the present value of the cash flows the assets is expected to generate over its life. This computation of value is the same as was discussed in the section about valuation of financial assets—that is, bonds and stocks. Once the value of the asset is determined, the firm can determine whether to invest in the asset by comparing its computed value to how much the asset costs to purchase. Following this decision-making procedure helps ensure the firm will maximize its value—that is, if an asset has a value to the firm that is greater than its cost, the firm’s value would be increased if the firm purchases the asset. Capital Budgeting Evaluation Techniques—in this section, the basic techniques that are used to make capital budgeting decisions are described.

Many formal methods are used in capital budgeting, including the techniques such as 

Accounting rate of return



Average accounting return



Payback period



Net present value



Profitability index



Internal rate of return



Modified internal rate of return



Equivalent annual cost



Real options valuation

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period. Net Present value Project Classifications Capital Budgeting projects are classified as either Independent Projects or Mutually Exclusive Projects. An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting criterion should be accepted. Mutually Exclusive Projects are a set of projects from which at most one will be accepted. For example, a set of projects which are to accomplish the same task. Thus, when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted. Of these three, only the Net Present Value and Internal Rate of Return decision rules consider all of the project's cash flows and the Time Value of Money. As we shall see, only the Net Present Value decision rule will always lead to the correct decision when choosing among Mutually Exclusive Projects. This is because the Net Present

Value and Internal Rate of Return decision rules differ with respect to their Reinvestment Rate Assumptions. The Net Present Value decision rule implicitly assumes that the project's cash flows can be reinvested at the firm's Cost of Capital, whereas, the Internal Rate of Return decision rule implicitly assumes that the cash flows can be reinvested at the projects IRR. Since each project is likely to have a different IRR, the assumption underlying the Net Present Value decision rule is more reasonable. Internal rate of return The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV. In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV, although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

Equivalent annuity method The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan. It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated. The use of the EAC method implies that the project will be replaced by an identical project. Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3-year project are compare to three repetitions of the 4-year project. The chain method and the EAC method give mathematically equivalent answers. The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations. Real options Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis tries to value the choices - the option value that the managers will have in the future and adds these values to the NPV.

Ranked projects The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended. Funding sources Capital budgeting investments and projects must be funded through excess cash provided through the raising of debt capital, equity capital, or the use of retained earnings. Debt capital is borrowed cash, usually in the form of bank loans, or bonds issued to creditors. Equity capital are investments made by shareholders, who purchase shares in the company's stock. Retained earnings are excess cash surplus from the company's present and past earnings. Need for capital budgeting 1.

As large sum of money is involved which influences the profitability of the firm making capital budgeting an important task.

2.

Long term investment once made can not be reversed without significance loss of invested capital. The investment becomes sunk, and mistakes, rather than being readily rectified, must often be borne until the firm can be withdrawn through depreciation charges or liquidation. It influences the whole conduct of the business for the years to come.

3.

Investment decision are the base on which the profit will be earned and probably measured through the return on the capital. A proper mix of capital investment is quite important to ensure adequate rate of return on investment, calling for the need of capital budgeting.

4.

The implication of long term investment decisions are more extensive than those of short run decisions because of time factor involved, capital budgeting decisions are subject to the higher degree of risk and uncertainty than short run decision.[2]

http://www.accountingtools.com/overview-of-capital-budgeting http://www.studyfinance.com/ (http://www.investopedia.com/university/capitalbudgeting/importance). Management Consultancy 2011 Ma. Elenita Balatbat Cabrera Published GIC Enterprise & Co., inc Metro Manola Business Finance and Phil Business Firms 2006 Nenita D. Mejorada Goodwill Trading Co. Quezon City Management Accounting 2011 Ma. Elenita Balatbat Cabrera