- Capital Budgeting: Features, Process, Factors affecting & Decisions
- FEATURES OF CAPITAL BUDGETING
- A) Project identification and generation:
- B) Project Screening and Evaluation:
- C) Project Selection:
- D) Implementation:
- E) Performance review:
- FACTORS AFFECTING CAPITAL BUDGETING:
- CAPITAL BUDGETING DECISIONS:
- Capital Budgeting (Definition, Advantages) | How it Works?
- How to Take Capital Budgeting Decisions?
- #1 – Payback Period
- Features:
- #3-Net Present Value Method
- #4- Internal Rate of Return (IRR)
- #5- Profitability Index
- Example #1
- Example #2
- Example #3
- Example #4
- Advantages of Capital Budgeting
- Limitations
- Conclusion
- Recommended Articles
- Capital Budgeting Best Practices — Learn How to Evaluate Projects
- Best Practices in Capital Budgeting
- Decisions actual cash flows
- Cash flow timing
- Cash flows are opportunity costs
- Cash flows are computed on an after-tax basis
- Financing costs are ignored from the calculations of operating cash flows
- More Resources
- Capital Budgeting and Various techniques of Capital Budgeting
- Features of Capital budgeting –
- Process ofCapital Budgeting–
- Various techniques of Capital Budgeting –
- Importance of capital budgeting →
- CAPITAL BUDGET
- REQUIRED RATE OF RETURN
- CAPITAL BUDGETING TECHNIQUES
- LIMITATIONS OF QUANTITATIVE TECHNIQUES

## Capital Budgeting: Features, Process, Factors affecting & Decisions

Capital budgeting is a company’s formal process used for evaluating potential expenditures or investments that are significant in amount. It involves the decision to invest the current funds for addition, disposition, modification or replacement of fixed assets.

The large expenditures include the purchase of fixed assets land and building, new equipments, rebuilding or replacing existing equipments, research and development, etc. The large amounts spent for these types of projects are known as capital expenditures.

Capital Budgeting is a tool for maximizing a company’s future profits since most companies are able to manage only a limited number of large projects at any one time.

Capital budgeting usually involves calculation of each project’s future accounting profit by period, the cash flow by period, the present value of cash flows after considering time value of money, the number of years it takes for a project’s cash flow to pay back the initial cash investment, an assessment of risk, and various other factors.

**Capital is the total investment of the company and budgeting is the art of building budgets.**

**Want to learn about Capital Budgeting?**

### FEATURES OF CAPITAL BUDGETING

1) It involves high risk

2) Large profits are estimated

3) Long time period between the initial investments and estimated returns

### A) Project identification and generation:

The first step towards capital budgeting is to generate a proposal for investments. There could be various reasons for taking up investments in a business. It could be addition of a new product line or expanding the existing one. It could be a proposal to either increase the production or reduce the costs of outputs.

### B) Project Screening and Evaluation:

This step mainly involves selecting all correct criteria’s to judge the desirability of a proposal. This has to match the objective of the firm to maximize its market value. The tool of time value of money comes handy in this step.

Also the estimation of the benefits and the costs needs to be done. The total cash inflow and outflow along with the uncertainties and risks associated with the proposal has to be analyzed thoroughly and appropriate provisioning has to be done for the same.

### C) Project Selection:

There is no such defined method for the selection of a proposal for investments as different businesses have different requirements. That is why, the approval of an investment proposal is done the selection criteria and screening process which is defined for every firm keeping in mind the objectives of the investment being undertaken.

Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to be explored by the finance team. This is called preparing the capital budget. The average cost of funds has to be reduced.

A detailed procedure for periodical reports and tracking the project for the lifetime needs to be streamlined in the initial phase itself. The final approvals are profitability, Economic constituents, viability and market conditions.

**Need Guidance? Ask from Experts!**

### D) Implementation:

Money is spent and thus proposal is implemented. The different responsibilities implementing the proposals, completion of the project within the requisite time period and reduction of cost are allotted. The management then takes up the task of monitoring and containing the implementation of the proposals.

### E) Performance review:

The final stage of capital budgeting involves comparison of actual results with the standard ones. The unfavorable results are identified and removing the various difficulties of the projects helps for future selection and execution of the proposals.

### FACTORS AFFECTING CAPITAL BUDGETING:

Availability of FundsWorking Capital | |

Structure of Capital | Capital Return |

Management decisions | Need of the project |

Accounting methods | Government policy |

Taxation policy | Earnings |

Lending terms of financial institutions | Economic value of the project |

### CAPITAL BUDGETING DECISIONS:

The crux of capital budgeting is profit maximization. There are two ways to it; either increase the revenues or reduce the costs. The increase in revenues can be achieved by expansion of operations by adding a new product line. Reducing costs means representing obsolete return on assets.

**Accept / Reject decision** – If a proposal is accepted, the firm invests in it and if rejected the firm does not invest.

Generally, proposals that yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the others are rejected. All independent projects are accepted.

Independent projects are projects that do not compete with one another in such a way that acceptance gives a fair possibility of acceptance of another.

**Mutually exclusive project decision** – Mutually exclusive projects compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects.

Only one may be chosen. Mutually exclusive investment decisions gain importance when more than one proposal is acceptable under the accept / reject decision.

The acceptance of the best alternative eliminates the other alternatives.

**Capital rationing decision** – In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process. In that, independent investment proposals yielding a return greater than some predetermined level are accepted. But actual business has a different picture.

They have fixed capital budget with large number of investment proposals competing for it. Capital rationing refers to the situation where the firm has more acceptable investments requiring a greater amount of finance than that is available with the firm. Ranking of the investment project is employed on the basis of some predetermined criterion such as the rate of return.

The project with highest return is ranked first and the acceptable projects are ranked thereafter.

**As the topic is vast we shall cover the techniques / methods with examples and the other relevant aspects of capital budgeting in the next article.**

Источник: `https://www.edupristine.com/blog/capital-budgeting`

## Capital Budgeting (Definition, Advantages) | How it Works?

Capital Budgeting refers to the planning process which is used for decision making of the long term investment that whether the projects are fruitful for the business and will provide the required returns in the future years or not and it is important because capital expenditure requires huge amount of funds so before doing such expenditure in capital, the companies need to assure themselves that the spending will bring profits in the business.

Capital Budgeting is a decision-making process where a company plans and determines any long term Capex whose returns in terms of cash flows are expected to be received beyond a year. Investment decisions may include any of the below:

- Expansion
- Acquisition
- Replacement
- New Product
- R&D
- Major Advertisement Campaign
- Welfare investment

The capital budgeting decision making remains in understanding whether the projects and investment areas are worth the funding of cash through the capitalization structure of the company debt, equity, retained earnings – or not.

### How to Take Capital Budgeting Decisions?

There are 5 major techniques used for capital budgeting decision analysis in order to select the viable investment are as below:

### #1 – Payback Period

Payback Period is the number of years it takes to recover the initial cost – the cash outflow – of the investment. The shorter the payback period, the better it is.

### Features:

- Provides a crude measure of liquidity
- Provides some information on the risk of the investment
- Simple to calculate

### #3-Net Present Value Method

NPV is the sum of the present values of all the expected cash flows in case a project is undertaken.

**NPV = CF0 + CF1/(1+k)1+ . . . + CFn/(1+k)n**

where,

The required rate of return is usually the Weighted Average Cost of Capital (WACC) – which includes the rate of both debt and equity as the total capital

### #4- Internal Rate of Return (IRR)

IRR is the discount rate when the present value of the expected incremental cash inflows equals the initial cost of the project.

i.e. when PV(Inflows) = PV(Outflows)

### #5- Profitability Index

Profitability Index is the Present Value of a Project’s future cash flows divided by the initial cash outlay

**PI = PV of Future Cash Flow / CF0**

Where,

CF0 is the initial investment

This ratio is also known as Profit Investment Ratio (PIR) or Value Investment Ratio (VIR).

### Example #1

A company is considering 2 projects to select anyone. The projected cash flows are as follows

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WACC for the company is 10 %.

**Solution:**

Let us calculate and see which project should be selected over the other, using the more common capital budgeting decision tools.

NPV For Project A –

**The NPV For Project A = $1.27**

NPV For Project B-

**NPV For Project B = $1.30**

Internal Rate of Return For Project A-

**The Internal Rate of Return For Project A = 14.5%**

Internal Rate of Return For Project B-

**Internal Rate of Return For Project B = 13.1%**

The net present value for both the projects is very close, and therefore taking a decision here is very difficult.

Therefore, we pick the next method to calculate the rate of return from the investments if done in each of the 2 projects. This now provides an insight that Project A would yield better returns (14.5%) as compared to the 2nd project, which is generating good but lesser than Project A.

Hence, Project A gets selected over Project B.

### Example #2

In case of selecting a project the Payback period, we need to check for the inflows each year and check in which year the outflow gets covered by the inflows.

Now, there are 2 methods to calculate the payback period the cash inflows – which can be even or different.

Payback Period for Project A-

**10 years, the inflow remains the same as $100 mn always**

Project A depicts a constant cash flow; hence the payback period, in this case, is calculated as Initial Investment / Net Cash Inflow. Therefore, for project A, in order to meet the initial investment, it would take approximately 10 years.

Payback Period for Project B-

**Adding the inflows, the investment of $1000 mn is covered in 4 years**

On the other hand, Project B has uneven cash flows. In this case, if you add up the yearly inflows – you can easily identify in which year would the investment and returns are close. So, for project B, the initial investment requirement is met in the 4th year.

On comparing, Project A is taking more time to generate any benefits for the entire business, and therefore project B should be selected over project A.

### Example #3

Consider a project where the initial investment is $10000. Using the Discounted Payback period method, we can check if the project selection is worthwhile or not.

This is an extended form of payback period, where it considers the time value of the money factor, hence used the discounted cash flows to arrive at the number of years required to meet the initial investment.

Given the below observations:

There are certain cash inflows over the years under the same project. Using the time value of money, we calculate the discounted cash flows at a predetermined discount rate. In column C above are the discounted cash flows, and column D identifies the initial outflow that is covered each year by the expected discount cash inflows.

The payback period would lie somewhere between years 5 & 6. Now, since the life of the project is seen to be 6 years, and the project gives returns in a lesser period, we can infer that this project has a better NPV. Therefore, it will be a good decision to pick this project which can be foreseen to add value to the business.

### Example #4

Using the budgeting method of the Profitability index to select between two projects, which are the options tentative with a given business. Below are the cash inflows expected from the two projects :

Profitability Index for Project A-

**The Profitability Index for Project A =$1.16**

Profitability Index for Project B-

**Profitability Index for Project B = $0.90**

The profitability index as well involves converting the regular estimated future cash inflows using a discount rate, which is mostly the WACC % for the business. The sum of these present values of the future cash inflows is compared with the initial investment, and thus, the profitability index is obtained.

If the Profitability index is > 1, it is acceptable, which would mean that inflows are more favorable than the outflows.

In this case, Project A has an index of $1.16 as compared to Project B, which has the Index of $0.90, which is clearly that Project A is a better option than Project B, hence, selected.

### Advantages of Capital Budgeting

- Helps in making decisions in the investments opportunities
- Adequate control over expenditures of the company
- Promotes understanding of risks and its effects on the business
- Increase shareholders’ wealth and improve market holding
- Abstain from Over or Under Investment

### Limitations

- Decisions are for a long term and therefore, not reversible in most of the cases
- Introspective in nature due to the subjective risk and discounting factor
- Few techniques or calculations are assumptions – uncertainty might lead to incorrect application

### Conclusion

Capital budgeting is an integral and very important process for a company to choose between projects for a long term perspective. It is a necessary procedure to be followed before investing in any long-term project or business.

It gives the management methods to adequately calculate the returns on investment and make a calculated judgment always to understand whether the selection would be beneficial for improving the company’s value in the long term or not.

### Recommended Articles

This has been a guide to what is Capital Budgeting and its definition. Here we will discuss how to make capital budgeting decisions using practical examples and explanations. We also discuss its advantages & disadvantages. You may learn more about Corporate Finance from the following articles –

Источник: `https://www.wallstreetmojo.com/capital-budgeting/`

## Capital Budgeting Best Practices — Learn How to Evaluate Projects

Capital budgeting refers to the decision-making process that companies follow with regard to which capital-intensive projects they should pursue.

Such capital-intensive projects could be anything from opening a new factory to a significant workforce expansion, entering a new market, or the research and developmentResearch and Development (R&D)Research and Development (R&D) is a process by which a company obtains new knowledge and uses it to improve existing products and introduce new ones to its operations. R&D is a systematic investigation with the objective of introducing innovations to the company’s current product offerings. of new products.

Whether such investments are judged worthwhile depends on the approach that the company uses to evaluate them. This is where capital budgeting comes in. For instance, a company may choose to value its projects the internal rate of returnIRR FunctionThe IRR function is categorized under Excel Financial functions.

IRR will return the Internal Rate of Return for a given cash flow, that is, the initial investment value and a series of net income values.

In financial modeling, as it helps calculate the return an investment would earn series of cash flows they provide, their net present valueNet Present Value (NPV)Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present.

NPV analysis is a form of intrinsic valuation and is used extensively across finance and accounting for determining the value of a business, investment security,, payback periods, or a combination of such metrics.

### Best Practices in Capital Budgeting

While most big companies use their own processes to evaluate projects in place, there are a few practices that should be used as “gold standards” of capital budgeting. This can help to guarantee the fairest project evaluation. A fair project evaluation process tries to eliminate all non-project related factors and focus purely on assessing a project as a stand-alone opportunity.

### Decisions actual cash flows

Only incremental cash flows are relevant to the capital budgeting process, while sunk costsSunk CostA sunk cost is a cost that has already occurred and cannot be recovered by any means.

Sunk costs are independent of any event and should not be considered when making investment or project decisions. should be ignored. This is because sunk costs have already occurred and had an impact on the business’ financial statements.

As such, they should not be taken into consideration when assessing the profitability of future projects. Doing so could skew the perception of management.

### Cash flow timing

Analysts try to predict exactly when cash flows will occur, as cash flows received earlier in the life of projects are worth more than cash flows received later.

Congruent with the concept of the time value of moneyTime Value of MoneyThe time value of money is a basic financial concept that holds that money in the present is worth more than the same sum of money to be received in the future.

This is true because money that you have right now can be invested and earn a return, thus creating a larger amount of money in the future. (Also, with future, cash flows that are received sooner are more valuable. This is because they can be used right away in other investment vehicles or other projects.

In other words, cash flows that occur earlier have a larger time horizon. This makes them more valuable than cash flow that occurs at a later date. Cash flow considerations are an important factor in capital budgeting.

### Cash flows are opportunity costs

Projects are evaluated on the incremental cash flows that they bring in over and above the amount that they would generate in their next best alternative use. This is done to quantify just how much better one project is over another.

To calculate this, management may consider the difference in the NPV, IRR, or payback periods of two projects.

Doing so provides a valuable capital budgeting perspective in evaluating projects that provide strategic value that is more difficult to quantify.

### Cash flows are computed on an after-tax basis

Since interest payments, taxes, and amortization and depreciation are expenses that occur independently of a project, they should not be taken into account when assessing a project’s profitability.

Assuming that the company will draw upon the same source of capital to finance such projects and that the cash flows of all projects will be recorded in the same tax environments, these considerations are essentially constants.

Thus, they can be removed from the decision-making process.

### Financing costs are ignored from the calculations of operating cash flows

Financing costs are reflected in the required rate of return from an investment project, so cash flows are not adjusted for these costs. The costs are typically congruent with the company’s Weighted Average Cost of Capital (WACC)WACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt.

The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator, which represents the cost the company incurs to run its current capital structure. During project valuations, the discount rate used is often the WACC of the company.

Therefore, this is another constant that can be ignored as well.

### More Resources

We hope you enjoyed reading CFI’s explanation of Capital Budgeting. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™FMVA® CertificationJoin 350,600+ students who work for companies Amazon, J.P. Morgan, and Ferrari certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following CFI resources:

- Budget HolderBudget HolderThe person who is ultimately responsible for ensuring that the budget is followed is known as the Budget Holder. Budget holders are usually the managers and operational directors of companies who are tasked by the owners/shareholders or the board of directors to ensure that the company follows its budget
- Due Diligence in Project FinanceDue Diligence in Project FinanceDue diligence in project finance involves managing and reviewing the aspects related to a deal. Proper due diligence ensures no surprises arise in regard to a financial transaction. The process involves a comprehensive examination of the transaction and preparation of a credit appraisal note.
- Project BudgetProject BudgetThe Project Budget is a tool used by project managers to estimate the total cost of a project. A project budget template includes a detailed estimate of all costs that are ly to be incurred before the project is completed.
- Types of BudgetsTypes of BudgetsThere are four common types of budgeting methods that companies use: (1) incremental, (2) activity-based, (3) value proposition, and (4) zero-based. The

Источник: `https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-budgeting-best-practices/`

## Capital Budgeting and Various techniques of Capital Budgeting

According to G.C. Lyrich “Capital budgeting is concerned with the allocation of firm`s financial resources among the available opportunities.

The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earnings from a project, with the immediate and subsequent streams of expenditure.”

It is simply long term planning for making and financing proposed capital investments or projects.

**Features of Capital budgeting –**

- Capital Budgeting decisions involve large amount of expenditure on proposed investments.
- Capital Budgeting decisions reflect the future streams of earnings and cost of a business concern and affects their growth, thus it has a long term impact on a business.
- Capital Budgeting decisions once implemented are Irreversible
- Capital Budgeting decisions are complex as it involves forecasting of future costs and profits

**Process of ****Capital Budgeting****– **

**(1) Identification, Screening and Selection of investment proposals –** Various projects from different departments of a firm are taken up and evaluated to conform with organization`s investment needs and projects which positively impact the future cash flows of the firm are selected.

**(2) Capital Budget Proposal –** After the screening and evaluation of projects, the chosen projects are subjected to capital budgeting tools to determine the future cash flows and their potential to achieve organizational objectives. Data is collected from various departments and requests of various department heads are also entertained while finalizing the projects and preparing a capital expenditure budget.

**(3) Approval and Authorization of capital expenditure budget – **Some additional research and analysis may be conducted before the selected projects are approved and authorized. Adequate funds are allocated to each projects and teams are appointed for implementation of the projects.

**(4) Project Tracking –** It involves monitoring of the work in progress and expenditure related to projects and communicating the performance to the Top Management. It aims to identify any problems associated with implementation of the project and take corrective actions to ensure smooth execution of projects.

**(5) Post-Completion Audit and Performance Review – **Projects may be subjected to an audit after a few years of its completion or during its implementation to assess whether it will be profitable to continue or not. All projects are not subjected to such audits but are reviewed to determine deviations in expected and actual performance.

### Various techniques of Capital Budgeting –

**(i) Payback period** – It is the time required to recover the initial investment (capital invested) in a project. It is a non-discounted cash flow method of capital budgeting.

**Payback period = Initial investment ÷ Total Cash inflow**

**Merits** –

- It is easy to calculate and simple to understand.
- It was an improvement of the Accounting rate of return method.
- It reduces the possibility of loss on account of obsolesce.

**Demerits** –

- It ignores time value of money.
- It ignores all cash inflows after the pay-back period.

If the actual pay-back period is less than the predetermined pay-back period, the project would be accepted.

**(ii) Post Pay-back Profitability Method** – This method overcomes the limitations of payback period by considering cash inflows after the payback period. It considers the returns after the payback period.

**Payback period =**

** Initial investment ÷ Total present value of future Cash inflow**

**Present value of Cash inflow = Cash inflow (1 – DR%)n**

**Here DR%= discounting rate and n = No. of years**

**Post Pay back Profitability = Cash inflow (Estd. Life – Payback period)**

**Post Pay back Profitability index = **

**Post pay back profitability ÷ Initial investment**

**(iii) Accounting Rate of Return Method** – It is a financial ratio which helps to evaluate returns and profit potential of a project. It calculates return on investment of a proposed project by taking into account the average income or profit generated by a project.

**ARR or Return on Investment = **

**(Average profit/income ÷ Original investment) X 100**

**Merits** –

- the accounting information rather than cash inflow.
- Considers the total benefits associated with the project.

**Demerits – **

- It ignores time value of money.
- It ignores reinvestment potential of a project.

If the actual accounting rate of return is more than the predetermined rate of return, the project would be accepted.

**(iv) Net present Value **– In this method cash inflows are considered with the time value of money. It is the difference between the total present value of future cash inflows and the total present value of future cash outflows.

**Net Present Value = **

**Total Present Value of Cash inflow – Total Present value of Cash out flow**

**Present value of Cash inflow = Cash inflow (1 – DR%)n**

** Here DR%= discounting rate and n = no. of years**

**Merits** –

- It recognizes the time value of money.
- It considers all the benefits that are derived a proposed project.
- It helps to select best method for mutually exclusive projects.

**Demerits** –

- It is difficult to understand and calculate.
- It needs discounting factors to calculate present values.

If the present value of cash inflow is more than the present value of cash outflows, it would be accepted. Cash inflows include Net Profit after tax + depreciation.

**(ii) Internal Rate of Return** – It is a rate at which discount cash flows to zero i.e. Internal Rate of Return is a point where Net Present Value(NPV) is equal to Zero.

**Steps to calculate IRR –**

- Find out positive net present value
- Find out negative net present value
- Find out Internal Rate of Return

**Internal Rate of Return = **

**[ Lower rate + ( Positive NPV ÷ Diff. in positive & negative NPV ) ] X DP**

**DP = Difference in percentage of positive & negative NPV**

**{Lower rate is the rate at which NPV is greater than Zero or NPV is positive}**

**OR**

**Internal Rate of Return = **

**[Lower + (NPV@ lower rate ÷ (NPV@lower rate — NPV@higher rate) )] X DP**

**Merits** –

- It considers the time value of money.
- It takes into account the total cash inflow and outflow.

**Demerits **–

- It is difficult to compute.
- It produces multiple rates which may be confusing.

**(iii) Profitability Index **– It is calculated on the basis of NPV and expressed in percentage. It is the ratio of the present value of Cash inflows and present value of cash outflows.

**PI = Present value of Cash Inflows ÷ Present value of cash outflows**

### Importance of capital budgeting →

**→** It is important as it creates accountability and measurability.

**→** Long term implication – Capital expenditure decision affect the company’s future cost structure over a long time span. Therefore risk should be minimized through systematic analysis of projects.

**→** Irreversible decision – Capital investment decisions are not easily reversible without much financial loss to the firm.

**→** Long-term commitment of funds – Long term investments lead to higher financial risk. Hence careful planning is must to reduce the financial risk.

**→** Capital budgeting is also vital to a business because it creates a structured step by step process that enables a business to –

- Develop and formulate long term strategic goals
- Seek out new investment projects
- Estimate and forecast future cash flows
- Facilitate transfer of information

Источник: `https://bbamantra.com/capital-budgeting/`

## CAPITAL BUDGET

Photo by: Mykola Velychko

Capital expenditures are the allocation of resources to large, long term projects. The capital budget is a statement of the planned capital expenditures. It is more than a simple listing, however, and is not a «budget» in the usual sense.

Given the nature of capital expenditures, the capital budget is best thought of as an expression of the ** goals ** and ** strategy ** of the firm. Creation of the capital budget is a central task that affects, and is affected by, all others areas of ** decision making.**

** ** The «capital budgeting process» can be envisioned as shown in Figure 1. Present and anticipated business conditions are the opportunities and constraints from which the goals of the firm are developed.

The goals drive the strategic decisions of capital budget and financing, but feasibility and consistency with the interdependent financing and capital budget decisions must be considered in setting the goals.

Operating decisions may be thought of as the tactical choices driven by strategy, but again feasibility and consistency of operating decisions must be considered in setting strategy. The process is in actuality part simultaneous, part iterative. Given the interdependency of goals, strategy, and tactics in a changing environment, the capital budget is properly considered as an active planning document, rather than a fixed conclusion.

From a narrow economic viewpoint creating the capital budget is relatively simple: a project should be accepted if the return is greater than the cost.

Projects are listed in order of decreasing return, and investment should continue until the marginal return (roughly, the return to the next dollar spent) is greater than marginal cost (roughly, the required rate of return on the next dollar spent). This simple, elegant statement of the problem masks a number of complications.

Projects of different

riskwill ly have different required returns, will be of different sizes and have different lives, and may be mutually exclusive or interdependent.

The rule of accepting projects until marginal return no longer exceeds marginal cost also assumes unlimited funds. This assumption is theoretically justified by the argument that if marginal return exceeds marginal cost, increasing the capital budget will return more than it costs, and more funds should be acquired.

There are, however, a number of reasons for limiting the size of the capital budget. Project analysis is often individual projects, but overall firm performance will be degraded if too many new projects are attempted in a short space of time.

Externally, lenders or investors may be unwilling to provide funds or may require added return or limitations on an overly ambitious management. Further, some attractive projects may simply not fit the goals and strategy of the firm. Investors and creditors may react adversely to new projects if they are inconsistent with the perceived nature of the firm.

Since capital budgeting is the concrete expression of the goals and strategy of the firm, capital budgeting must often consider factors that defy exact measurement or even definition.

### REQUIRED RATE OF RETURN

The marginal cost of the project is expressed as a required rate of return (sometimes called the «hurdle rate»). Estimation of the required rate is integral to evaluating projects and setting the capital budget. The controlling concept is that of ** opportunity cost.**

** ** Opportunity cost reflects the idea that the relevant cost of using a resource is the rate of return on forgone alternative opportunities of similar risk.

For projects that are extensions of or similar to the normal operations of the firm, and so have a similar risk profile, a readily available comparable use of funds is reinvesting in the firm itself.

For these projects, the opportunity cost/required rate of return/hurdle rate can be approximated by the firm's weighted average cost of capital (WACC). The WACC is the rate of return that just meets investor expectations, leaving the value of the shares of the firm unchanged.

WACC is computed by first estimating the rate of return required to meet the obligations for each source of capital. These required rates are then weighted according to the target

capital structureof the firm to obtain the overall rate of return required to meet the combined obligations—the WACC. This is the return that could be obtained by reinvesting the funds within the firm (downsizing).

Where the project is outside the normal operations of the firm or has a different risk profile, the WACC is not be a good estimate of the required rate of return on the project.

The required rate of return may be estimated by using the WACC for firms similar in nature to the project, or by applying capital asset pricing model at the estimated systematic risk of the project.

These comparison-based estimates are satisfactory for projects of standardized technology that does not require that the firm develop new expertise. Where the project is nonstandard or innovative, or requires developing new expertise, such comparison may underestimate the risk.

In such cases the required return on the new project must be arrived at by ad hoc adjustment. ** Decision tree, Monte Carlo, ** or other risk analysis tools are helpful.

### CAPITAL BUDGETING TECHNIQUES

Various techniques have been developed for application to individual projects. The simplest individual technique is the payback period—the time required for total cash inflows to equal total cash outflows.

Projects are ranked according to payback period, and accepted if the payback period is below some maximum length.

While simple to compute, there is no generally accepted method to set the maximum payback period, the time value of money is not considered, and cash flows past the payback period are ignored.

An alternative is the

accountingrate of return—the average annual change in accounting earnings due to the project expressed as a percent of the initial cost. This technique also has no generally accepted standard, fails to consider the time value of money, and is accounting earnings rather than on actual cash flows.

** Discounted cash flow ** (DCF) techniques are preferable because they consider the time value of money, are actual cash flows rather than accounting profits, and have a definite standard.

These techniques compare the rate of return from a project to the rate of return available on other investments of similar risk—a comparison of marginal return to marginal cost. The two widely used DCF techniques are the concept of present value.

The present value of a series of cash flows is the amount that, if invested at the required rate of return for the project, will re-create the expected cash flows from the project.

The net present value (NPV) is computed as the present value of the project cash flows minus the cost of the project. If NPV is negative, the present value of the cash flows from the project is less than the cost of the project—i.e., it would be cheaper to generate the cash flows by investing at the required rate than by undertaking the project.

Since the cash flows could be created more cheaply by investing at the required rate, the project rate of return is below the required rate, and rejection is indicated. Alternately stated, rejecting the project and investing the cost of the project elsewhere would create larger cash flows than accepting the project.

Where NPV is positive, it is cheaper to generate the cash flows by undertaking the project than by investing at the required rate of return—i.e., the project rate of return is greater than the required return, and acceptance is indicated. Alternately stated, investing the project creates larger cash flows than investing elsewhere.

NPV is sometimes described as the change in the value of the firm if the project is accepted.

The internal rate of return (IRR) is the rate of return that would be required to exactly re-create the cash flows from an investment equal to the cost of the project. The IRR is the rate of return provided by the project if accepted. If the IRR is greater than the required rate of return, acceptance is indicated. If the IRR is below the required rate of return, rejection is indicated.

While the IRR technique appears simpler to understand and apply, it can be misleading if there is a limit to the number of projects that can be accepted or if projects are mutually exclusive, so that a ranking technique is necessary.

While IRR and NPV will always give the same accept/reject decision, the ranking of projects on IRR may differ from the ranking on NPV. This difference arises because of differences in the implicit assumptions about the rate of return on cash flows from the project.

The NPV technique implicitly assumes reinvestment of cash flows at the required rate of return, while the IRR implicitly assumes reinvestment of cash flows at the IRR. The NPV criterion is considered superior because it is ly that the actual reinvestment rate will be close to the required rate.

The IRR, on the other hand, may depart widely from the actual reinvestment rate. The reinvestment rate is also important when considering projects of different lives.

It is possible that a long project of lower return may be preferable to a short project of high return if the cash flows from the short project will be reinvested at a low rate. Where information about the actual reinvestment rate is obtainable, however, both NPV and IRR can be modified to reflect this rate. This is accomplished by compounding all cash flows forward until the end of the project.

A further potential problem is that, where net cash inflows are required at some point during the life of the project, IRR becomes ambiguous because multiple solutions exist.

### LIMITATIONS OF QUANTITATIVE

TECHNIQUES

An accept or reject indication on the above criteria does not mean that a project should be automatically accepted or rejected. Many other factors need to be considered. First, the criteria are estimated cash flows and an estimated required rate.

The estimates are themselves subject to uncertainty and this may lead to an increase or safety factor in the «hurdle.» Second, as noted, the estimates proceed on an individual project basis, and there may be an interaction between projects.

Third, and perhaps most important, the criteria consider only cash flows, and some factors cannot be reduced to a monetary basis. It must be remembered that a capital budget is in reality the strategy chosen to reach the goals of the firm.

The indications of the quantitative economic analysis are only a part of the strategic planning process and are subsidiary to overall strategic considerations. Unless a project is compatible with the goals of the firm, it will not be accepted.

Conversely, if a project has nonmonetary benefits or interaction with other projects, it may be accepted despite a negative indication. Again, the capital budget is a planning document. The greatest contribution of the application of the capital budgeting techniques is not the indicated decision, but the heuristic benefits of greater understanding.

Finally, ethical standards are a vital part of the strategic considerations. An otherwise acceptable project may be unacceptable on ethical grounds. The social impact of projects has become increasingly important.

It is necessary to consider the ** externalities ** —the effects of the project that are not felt by the firm. Externalities include such items as environmental impact and required increase in ** infrastructure.**

** **

Emery, Douglas R., John D. Finnerty, and John D. Stowe.

Principles of Financial Management.Upper Saddle River, NJ: Prentice Hall, 1998.

Levy, Haim, and Marshall Sarnat. * Capital Investment and Financial Decisions. * 5th ed. New York: Prentice Hall, 1994.

Pinches, George E. * Essentials of Financial Management. * 5th ed. New York: HarperCollins, 1996.

Scott, David F., Jr., and others. * Basic Financial Management. * Upper Saddle River, NJ: Prentice Hall, 1999.

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