Capital Budgeting and Decision Methods
Firms use several methods for evaluating proposed capital budgeting projects. The main methods are: the payback method, the net present value method, and the internal rate of return methods. This chapter explains the application of each of these methods and how to adjust for differential project risk. After reading this chapter and working through the problems, you should be able to evaluate and rank proposed projects based on these techniques.
What You Should Know From This Chapter:
1. Explain the capital budgeting process:
Capital budgeting is the process of evaluating proposed long-term investments. Once the firm has identified a list of potential investment projects, the next step in the process is to estimate the expected cash flows and riskiness of each potential project. Based on these estimates, the manager must evaluate each project and decide which set of projects are the best for the firm to undertake. The primary decision methods used to evaluate the projects are payback, net present value, and internal rate of return.
2. Calculate the payback period, net present value, and internal rate of return for a proposed capital budgeting project:
The simplest capital budgeting method is the payback method. The analyst must calculate the number of years it will take to recoup the project’s initial investment. This is done by adding up the project’s cash inflows one year at a time until the sum equals the amount of the project’s initial investment. The number of years is the payback period. To evaluate this method, the manager must have in mind a particular number of years that is acceptable to the firm. If the payback period is less than or equal to that predetermined number, then the project is accepted.
The net present value (NPV) of a proposed project is equal to the present value of the cash inflows minus the present value of the cash outflows (which is usually the initial investment). The general equation is:
where CFt is the cash flow at time t, k is the appropriate discount rate. The project is acceptable if the NPV is greater than or equal to zero and unacceptable otherwise. An NPV profile that shows the NPV for various discount rates will show how sensitive the project’s NPV is to the discount rate assumption.
Internal rate of return (IRR) is the rate of return the project will earn, given its incremental cash flows and initial investment. It is the discount rate that makes the project’s NPV = 0. IRR is calculated by setting the NPV to zero and solving for the discount rate. This can be done mathematically using trial and error, but a financial calculator makes the solution of this type of problem much easier. A project is acceptable if the IRR is greater than or equal to the firm’s required rate of return (or hurdle rate).
It will generally be the case that the accept or reject decision under NPV and IRR will be the same. However, when projects are mutually exclusive, there may be instances in which the two methods give conflicting accept/reject decisions. In such a case, the project with the highest NPV should be chosen since it will add the most to firm value.
The IRR method assumes that future cash flows in a project are reinvested at a rate of return equal to the IRR. This can result in overly optimistic expectations when the IRR is high and cash flows cannot be reinvested. To produce more realistic results, the Modified Internal Rate of Return (MIRR) method was developed. This method assumes that future cash flows from a project are reinvested at a rate of return equal to the cost of capital. This will give you an amount that is called the terminal value. Once you have this value, divide it by the original investment raised to 1/n –1. The rate of return now calculated is often more realistic because it is lower than the expected IRR. Again, the assumption is that the cash flows will be reinvested—even at the cost of capital.
MIRR is the modified internal rate of return and
FV= Future value
PV= Present value
n = number of investment periods
3. Describe capital rationing and how firms decide which projects to select:
Capital rationing is the process of setting dollar limits on the total size of the capital budget. Although this practice may not be consistent with shareholder wealth maximization, it is not uncommon for firms to ration capital. If capital rationing is imposed, then financial managers should seek the combination of capital budgeting projects that maximizes the value of the firm within the capital limit.
4. Measure the risk of a capital budgeting project:
Financial managers are generally risk averse and will prefer projects that are less risky to those that are more risky, all else equal. To measure the risk of a capital budgeting project, managers look at how the project would affect the risk of the firm’s existing asset portfolio. To do this, you must compare the coefficient of variation (CV) of the returns on the existing portfolio (based on the probability distribution of the IRR) with the CV of the portfolio including the new project. The formula for CV is:
The difference between the two CVs is a measure of the risk of the capital budgeting project and can be used to develop a risk adjusted discount rate.
5. Explain risk-adjusted discount rates:
One way to factor risk into the capital budgeting process is to adjust the required returns used in NPV and IRR analysis upward for higher-than-average risk projects and downward for projects that have lower-than-average risk. The resulting required return is called a risk-adjusted discount rate (RADR) and is also often called a “hurdle rate” since it is the rate that the IRR must exceed to be acceptable. If the CV is the risk measure that is being used by the firm, a RADR can be calculated by defining a percentage change in CV that the manager feels will require an adjustment in required rate of return. This adjustment is a subjective decision and will not be the same for all firms. Note that adjusting the discount upward will make NPV lower and will make it less likely that the calculated IRR will exceed the hurdle rate.