Overview: Capital budgeting is the process of deciding what projects to do. As such it is just a means of doing cost-benefit analysis.
There are many capital budgeting techniques that firms can use. These techniques do not always lead to the same accept-reject decision, so it is necessary to decide what a good capital budgeting technique looks like.
NPV is the best. It is the standard against which all methods are judged. Properly applied and understood, NPV is almost everything in finance!
- An ideal Capital Budget technique should:
use cash flows and not earnings
consider ALL relevant cash flows.
account for the time value of money
be able to correctly select among mutually exclusive projects.
be have a consistent and easy to apply decision rule.
if properly applied lead to higher shareholder value.
be relatively easy to explain
Net Present Value (NPV)
NPV is the best! It satisfies all of our criterion above. It is easy to use and will lead to increased shareholder wealth.
NPV = PV benefits - PV Costs
= Initial cost + PV(expected future cash flows)
Internal Rate of Return (IRR)
The discount rate that makes NPV equal to zero.
See table 6.3 of Ross Westerfield and Jaffe
If cash flows are not "normal" than problems: different IRR for every sign change.
For investing :
For "normal" cash flows: Accept the project if IRR > cost of capital on the project. Why? IRR> r is the same as NPV > 0.
If cash inflow, followed by all negative, accept if IRR <>
- Modified IRR
Way around the multiple IRR problem is to combine the cash flows until only one sign change exists. (i.e. take present values and add positive and negative together.
- Way around scales differences is to use incremental IRR. This involves finding the difference between the size of the two cash flows.
- Profitability Index
for normal cash flows PI = PV benefits / initial cost
(that is PV of cash flows after the first cash flow)/ initial cost
Some firms also use NPV/Initial cost.
Benefit: good is rationing
Disadvantage: still have scale problems--solution: use incremental cash flows
How many years it takes get the investment back.
Example: project costs 1000, pays back 300 per year
Payback = 3.33 years
Problems: arbitrary cut-off, ignores all cash flows after payback, ignores time value of money, leads to short-term thinking
Advantage: Easy!!! Managers like it.
- Discounted Payback
same as Payback period, but use discounted cash flows in stead of regular cash flows.
Average Accounting rate of return---possibly my least favorite method!
Example: accept a project is average Return on Assets is greater than some hurdle rate.
Does not use cash flows, does not consider time value of money, has arbitrary decision rule.
Only good things, is that it uses data that is already available and often times pay of middle managers is tied to ROI or ROA.