The principles of capital budgeting and project
evaluation
Introduction
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
Capital budgeting is the planning process used to determine whether a
company's long term investment such as new machinery, replacement
equipment, new plants, new products, and research development projects
are worth pursuing. It is an integral part of any financial management and it
helps the company allocate its limited resources to capital projects that
increase shareholder wealth. Capital budgeting requires evaluating projects
and only accepting those that meet the required rate of return criteria. This
paper discusses the principles and techniques of capital budgeting and
project evaluation in detail.
Principles of Capital Budgeting
There are some key principles that companies follow for capital budgeting
and project evaluation:
1. Accept/Reject Rule: This principle states that companies should only
accept projects whose expected return is higher than the minimum
acceptable return or hurdle rate set by the company. Projects with lower
returns should be rejected.
2. Cash Flow Considerations: Capital budgeting decisions are based on
forecasts of future cash flows rather than accounting profits. Expected future
cash inflows and outflows over the life of the project are estimated and
discounted to their present value.
3. Opportunity Cost of Capital: The required minimum rate of return used as
hurdle rate is the opportunity cost of capital which is the return expected by
investors from other investments with similar risk. This ensures projects
create value above the cost of capital.
4. Systematic Evaluation Process: A structured process involving
identification, analysis and selection of projects ensures an objective
evaluation. All relevant cash flows are carefully estimated and risks are
accounted for.
5. Incorporate Risk Adjustments: As capital budgeting deals with forecasts,
risk adjustments are important. Riskier projects must offer higher returns
than less risky ones to compensate investors for the uncertainty. Risk
adjusted discount rates are used.
6. Consider Mutually Exclusive Projects: When choosing between similar
projects requiring the same resources, companies select the one with highest
NPV or other metrics. Only one such project can be accepted.
7. Include Sunk Costs for Decision Making: Only relevant incremental cash
flows are considered for a go/no-go decision. Sunk costs incurred before the
decision point do not affect whether to proceed with a project.
8. Evaluate Impact on Firm Value: The ultimate goal is to maximize
shareholder wealth. Projects must be evaluated on their ability to create
value for the company above its cost of capital.
Techniques of Capital Budgeting
There are several quantitative techniques commonly used for evaluating
projects and ranking them in order of desirability:
1. Net Present Value (NPV): This discounts the project's expected future cash
flows to the present using the discount rate. It measures the value created
by the project above the initial investment. Projects with positive NPV that
create value are accepted.
NPV = Present Value of Future Cash Inflows - Initial Investment
2. Internal Rate of Return (IRR): It is the discount rate that makes the NPV of
a project equal to zero. The IRR indicates the expected return from the
project. Projects with IRR higher than the hurdle rate are accepted.
3. Payback Period: It is the number of years required to recover the initial
investment through cash inflows. Shorter payback periods are preferred as
they indicate faster recovery of funds for reinvestment.
4. Profitability Index (PI): It is the ratio of present value of future cash flows to
initial investment. Projects with PI greater than one, where present value of
benefits exceeds costs, are accepted.
5. Accounting Rate of Return (ARR): Measures annual profits as a percentage
of the average investment. Higher ARR indicates greater returns per unit of
resources invested.
6. Benefit-Cost Ratio (B/C Ratio): It is the ratio of present value of future cash
inflows to initial investment. Projects with B/C ratio greater than one are
accepted.
7. Discounted Payback Period: It discounts future cash inflows at the required
rate of return. Shorter discounted payback period means quicker recovery of
investment after adjusting for time value of money.
All the above techniques have their own strengths and shortcomings.
Companies usually employ multiple methods to enable objective evaluation
and reduce risk of wrong decisions.
Project Identification and Screening
The first step in the capital budgeting process is to identify and screen
potential investment opportunities. There are various ways in which
companies source new projects:
- Customer demand changes and new markets: New projects may arise to
develop products for emerging demand or new customer segments.
- Technological developments: Advances in production methods or new
technologies create scope for cost savings or improved products/services.
- Competition or industry changes: Companies may pursue projects reacting
to competitive threats or changes in industry dynamics/regulations.
- Internal ideas: Employees involved in operations may identify scope for
efficiency, automation, process innovation etc. encouraging new
investments.
Once identified, projects undergo preliminary screening to shortlist only
potentially viable ones for detailed evaluation later. Companies may apply
some thresholds like:
- Minimum IRR, payback or other returns
- Minimum project size
- Fit with company's objectives and strategy
- Technical feasibility
- Availability of required resources
- Preliminary market and financial assessment
This early screening filters out obviously sub-standard projects before
allocating scarce managerial time and resources for detailed analysis. Only
feasibly projects are studied further.
Estimating Cash Flows
Accurate cash flow estimation is vital for capital budgeting since decisions
are based on expected future monetary impacts. Cash inflows and outflows
are forecasted for each period of the project's lifetime. Estimation requires
making reasonable assumptions about:
- Sales volumes and prices
- Variable and fixed costs of production
- Working capital changes
- Income taxes on profits
- Replacement of equipment
- Proceeds from sale of assets
Cash flows are ideally estimated conservatively without building in strategic
optimism. Companies consider factors like:
- Market potential and size determined via surveys
- Competitive landscape and industry outlook
- Production/operational plans and estimates
- Input costs based on historical trends and contracts
- Inflationary impacts on revenues and expenses
- Terminal value of assets after end of prediction period
Sensitivity analysis is also performed to gauge impacts of reasonable
variations in key assumptions. This ensures forecasts account for inherent
uncertainties and risks adequately.
Capital Costs
Capital costs refer to the initial investment required to undertake a capital
budgeting project. They are also called first or sunk costs as they must be
incurred upfront but do not affect future operating decisions. These costs
include:
- Equipment, plant, machinery, infrastructure
- Preliminary design, permits and legal costs
- Installation, construction and commissioning
- Working capital buffers
- Land and property costs
For expansion/replacement projects, the salvage or resale value of existing
assets is deducted from new investment. Capital costs are estimated as
accurately as possible using supplier quotes, past project data, industry
standards etc. Contingency reserves are also kept to cover unforeseen cost
escalations.
Relevant Cash Flows
Not all estimated cash flows are equally important for capital budgeting. Only
incremental cash flows post the investment decision matter. Sunk costs
incurred till the decision stage do not alter the accept/reject choice, so are
ignored as per the sunk cost principle.
Relevant cash flows considered are:
- Initial capital investment outflow
- Incremental annual operating cash inflows/outflows from the project
- Extra working capital tied in/released each period
- Cash flows relating to terminal disposal/salvage of project assets
Cash flows of different periods must also be adjusted to a common basis
using discounted present value for objective evaluation across time. This is
done using a risk-adjusted discount rate as explained later.
Risk Analysis
Since capital budgeting deals with forecasts, uncertainty and risks are
inherent. Ignoring risks can lead to poor investment decisions. A prudent
analysis involves:
1. Identifying Key Risks
Key risk factors like demand fluctuations, exchange rate volatility, raw
material price risk, technology obsolescence, regulatory changes etc. are
recognized upfront.
2. Risk Simulation
Sensitivity, scenario and probabilistic analysis are conducted to simulate
impacts of variations in critical assumptions. This gauges robustness of
projects.
3. Risk Adjusted Discounting
Discount rate used to derive NPV includes premium for non-diversifiable,
systematic or market risk faced by the project. Higher risk requires higher
returns.
4. Adjusting Cash Flow Estimates
Cash flows can be adjusted downward in pessimistic scenarios or
probabilities of downside risks factored in to capture uncertainty.
5. Incorporating Options
For flexible projects, optionality or ability to modify course of action based on
future events is valued as a risk mitigant using tools like decision trees.
6. Assessing Risk Exposure
Risk exposure in absolute ($) and relative (%) terms across quantifiable
factors is measured for better comprehension of threats.
7. Qualitative Risk Factors
Strategic and unforeseeable risks are discussed qualitatively alongside
quantitative analysis for holistic understanding.
This comprehensive analysis helps identify risk-return tradeoffs to choose the
optimal investment decision.
Minimum Attractive Rate of Return (MARR)
Given limited capital, companies rationally expect a minimum acceptable
return from long term investments. This opportunity cost is called Minimum
Attractive Rate of Return (MARR). Key considerations in determining MARR
are:
1. Cost of Capital
Cost of capital is the weighted average return required by the company's
capital providers - debtholders, preferred shareholders and common
stockholders. It reflects risks of the company's existing assets.
2. Industry Risk
The systematic risk or volatility associated with entire industry's prospects
impacts required compensation for investing. Riskier industries have higher
MARR.
3. Country/Economic Risk
Macroeconomic stability, political environment, infrastructure quality,
taxation policy of the nation influence investment risks. Emerging markets
require higher returns.
4. Competition Level
Intensity of competition, ease of entry/exit affects stability of cash flows.
High competition raises opportunity cost as alternative uses of capital exit.
5. Operating Leverage
Higher operating leverage means more volatile earnings and riskier cash
flows. Riskier projects deserve greater returns.
6. Financial Leverage
Use of debt in capital structure introduces financial risk increasing required
returns. Projects must offer surplus to cover interest costs.
7. Project Specific Risks
Technology, demand, regulatory and other unique risks pertinent to each
project are incorporated to ensure adequate reward per unit risk.
MARR thus represents minimum returns across different sources, magnitudes
and diversification levels of risks. Projects with expected return below MARR
are rejected.
Project Evaluation Models and Discounting
Different techniques and models are used to evaluate projects and shortlist
optimum ones. Key models apply discounting to determine present values:
1. Net Present Value (NPV)
NPV is the most popular technique that discounts future net cash flows (CIn -
COut) to the present using cost of capital as discount rate. It captures time
value explicitly.
NPV = C0 + C1/(1+r) + C2/(1+r)2 +...+Cn/(1+r)n
Where,
C0 is initial investment
C1-Cn are annual net cash flows in years 1 to n
r is discount rate
Projects with positive NPV create value and are accepted.
2. Internal Rate of Return (IRR)
IRR is the discount rate that makes NPV equal to zero. It is the expected
annualized return rate of the project itself.
Projects earning IRR higher than MARR are accepted. IRR is useful for
independent projects but not for mutually exclusive projects.
3. Profitability Index (PI)
PI is the ratio of present value of future cash inflows to initial investment. It is
a measure of financial yield of the project.
PI = PV of all future cash inflows / Initial investment
Projects with PI greater than 1 are value accretive.
4. Payback Period
Payback is number of periods for cumulative cash inflows to recover initial
cash outflow. It measures liquidity and risk aspects rather than profitability
alone.
Shorter payback is preferred as it demonstrates faster reinvestment of funds.
5. Discounted Payback Period
To account for time value explicitly, payback cash flows are discounted at
MARR to arrive at number of periods. Combined discounting and liquidity
measure.
6. Decision Trees
For projects with flexible options, decision trees map all future contingent
decisions and associated probabilistic cash flows to identify optimal course of
action.
These techniques enable objective ranking and selection of projects offering
highest return for a given level of risk.
Capital Rationing
In reality, companies face constraints in availability of capital relative to
opportunities. Capital rationing poses challenges due to limited flexibility in
choice of investments.
Some approaches used under capital rationing:
- Set an NPV cutoff point for available funds to maximize total NPV.
- Accept projects in descending IRR order until funds deplete even if positive
NPV projects remain pending.
- Apply optimization techniques like linear programming to maximize total
returns subject to capital availability constraint.
- Consider only short-term high return projects instead of long duration value
creators.
- Phase investments and implement most urgent high impact projects earlier.
- Negotiate joint venture funding or external financing selectively.
- Reconsider least attractive existing assets to free capital for superior
prospects.
Post-Completion Audit
Capital budgeting is an ongoing process with each step informing others.
Post-completion auditing forms critical feedback loop for decision making
quality and process improvements. Key aspects reviewed are:
- Actual vs estimated performance on time and within costs
- Deviation analysis for reasons behind variances in key assumptions
- Effects of unforeseen internal/external developments on project earnings
- Operational efficiency gained or issues encountered in implementation
- Lessons learnt for estimating uncertain factors more accurately in future
- Robustness of risk analysis and assumptions made originally
- Economic viability at actual input costs, yields and market conditions
- Continued fit and relevance of project with evolving strategies
Outcomes help strengthen accuracy of forecasting techniques, identify new
opportunities and potential project risk controls. This enhances allocative
efficiency of future capital budgeting rounds.
Capital Rationing Problem
Companies often have more positive NPV projects worth pursuing than
available funds for investments. This situation of capital rationing poses a
challenging optimization problem to managers. One approach could be:
Step 1) Sort all projects in descending order of their NPV
Step 2) Pick projects sequentially as per NPV rank until capital budget is
exhausted
Step 3) Calculate the total NPV of the selected project portfolio
Step 4) Compare it with total NPV achievable from other portfolio selections
A more efficient approach is using Linear Programming as below:
Let,
X1, X2, X3... Xn = Decision variables representing scale of investment in
each project
NPV1, NPV2, NPV3...NPVn = NPV of corresponding projects
B = Capital budget availability
C1, C2, C3...Cn = Capital costs of projects
The linear programming problem is:
Maximize Z = NPV1X1 + NPV2X2 +...+ NPVnXn
Subject to constraints:
C1X1 + C2X2 +...+ CnXn ≤ B
X1, X2, X3...Xn ≥ 0
The linear programming solver will provide the optimal scale of investment in
each project (values of X1, X2, X3...Xn) that maximizes the total portfolio
NPV, subject to the capital constraint.
This allocates capital more efficiently than simple NPV ranking by exploiting
interactions between projects' costs and returns.
Risk Adjusted Cost of Capital
Since capital budgeting deals with future uncertainty, the discount rate used
must compensate for the risk of projected cash flows. This leads to the
concept of Weighted Average Cost of Capital (WACC).
WACC is calculated as the weighted average of the costs of all sources of
funds used by the company adjusted for risks.
WACC = Ke * (E/V) + Kd * (D/V) * (1 - t)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
V = E + D
t = Corporate tax rate
Cost of each component is weighted by its proportion in the total funding
mix.
Ke is estimated using Capital Asset Pricing Model (CAPM) accounting for non-
diversifiable systematic risk:
Ke = Rf + β * (Rm - Rf)
Where,
Rf = Risk free rate
Rm = Expected market rate of return
β = Beta measuring relative risk of stock vs market
WACC incorporates overall risk faced by the company. Projects bearing
comparable risk levels are discounted at WACC for fair evaluation. Riskier
projects may apply a premium over WACC.
Mutually Exclusive Projects
Often organisations have to choose between capital projects that despite
differing technology/design address the same business need and are thus
mutually exclusive i.e. only one can be implemented due to resource sharing.
Key steps for selecting amongst mutually exclusive projects:
1. Forecast cash flows for all long list of options
2. Apply appropriate discount rate (WACC usually)
3. Compute NPV, IRR, PI or other metrics of all alternatives
4. Rank projects basis evaluation measure e.g. highest NPV
5. Accept the top ranking project providing maximum value
6. If two projects are close, conduct sensitivity analysis of key assumptions
7. Consider strategic qualitative factors in decision making
8. Check optimality via decision tree representing future flexibility
9. Recommend best solution in present context of information available
Although IRR comparisons are invalid for mutually exclusive choices, overall
process of detailed evaluation enables optimal capital allocation.
Replacement Decisions
Replacement decisions arise when existing assets can be replaced by new
more efficient/productive alternatives before the end of their economic life.
Key issues examined are:
1. Remaining Life - Scrap value of existing asset if continues in use till the
end
2. Terminal Value - Resale value if disposed before the end of useful life
3. Cash Flow Impacts - Savings from improvements less additional costs of
replacement
4. Timing Flexibility - Ability to defer replacement if economic conditions
change
5. Opportunity Costs - Returns foregone from investing scrapped funds
elsewhere
Projects are compared on NPV and IRR basis to reflect changing cash flows
from retention versus replacement. Earlier retirement is favored if positive
net present value.
Decision Trees
For long term capital projects with multiple stages of investments over time
and uncertainty resolution, decision tree analysis is potent. It systematically
maps:
- Key future decision points and possible options/strategies at each node.
- Uncertain events probabilistically through chance nodes linking decisions.
- Timing and estimated cash flow impacts of decisions and events.
- Optimal choices backwards recursively maximizing expected monetary
value.
This quantifies flexibility value when options to abandon, defer, expand or
alter projects exist contingent on uncertainty realizations. Flexible thinking
aids robust investment decisions.
Illustrative Capital Budgeting Case Study
A manufacturing company ABC is evaluating two potential capital projects -
Project X and Project Y requiring similar scale of initial investment.
Project Details:
Project X Project Y
Capacity (units) 5000 6000
Capital Cost ($) 500,000 520,000
Life 5 years 6 years
Estimated Cash Flows (in $000s):
Years Sales Costs Net Cash Flow
1 1,000 250 750
2 1,500 300 1,200
3 1,800 350 1,450
4 2,000 400 1,600
5 2,200 450 1,750
6 - - -
Company's WACC is 12%. Other details:
- Projects are mutually exclusive
- Sunk costs have already been incurred
- Cash flows are expected values, risks ignored for simplicity
Evaluate the projects and recommend optimal selection using NPV and IRR.
