Capital Budgeting Techniques
Capital Budgeting Techniques
Investment Appraisal Methods
At the core of investment appraisal is the fact that a firm should only take a project if doing so creates value for the owners of the firm. Due to its ability to consistently lead to the maximization of shareholder wealth, the Net Present Value (NPV) approach stands out as the most appropriate for appraising investments (Baker & Powell, 2005, p.229). What follows is a brief discussion of three main investment appraisal techniques including the NPV.
Payback Period
The time it takes for a capital project to break even is a crucial concern for financial managers (Baker & Powell, 2005, p.246). The payback period is just the time it takes for the project to generate enough cash flows to recover the initial capital outlay. Implicit under this method is the idea that firms would invest in projects that promise a quick recovery of initial investments as opposed to the rest. With an even occurrence of cash flows in each year, the payback period is calculated as below.
Given below is the timeline for a hypothetical project with various cash flows:
| Project Year(t) 0 1 2 3 4 |
| Net Cash flow(£) -100,000 30,000 40,000 50,000 60,000
Cumulative NCF -100,000 -70,000 -30,000 20,000 80,000 |
The year before full recovery is Year 2
Decision rules for Payback Period
The first step in using this approach is for the management to set an acceptable payback period. With that period in place, all independent projects with payback periods below or equal to the cutoff should be accepted (Baker & Powell, 2005, p.248). With mutually exclusive projects, the management should accept only the project with the shortest payback period.
Advantages
For one, it is relatively easy to understand the Payback Period as a method of investment analysis (Baker & Powell, 2005, p.248). This intuitive ease renders the method appropriate in cases where the management does not want carry out complex analyses. Secondly, using the Payback Method offers the management to easily gauge the liquidity and risk of a project. Ability to know when the project will recover its initial costs allows the management to prepare for liquidity shortfalls. This is very important for firms in liquidity constrained industries such as technology.
Disadvantages
Much as it is a simple method to use, the Payback method also presents a number of problems for those using it (Baker & Powell, 2005, p.248). The shortcomings render the method an unsophisticated and misleading approach to investment appraisal. One of the problems with this approach is the lack of any firm cutoff guidelines for establishing a payback period. It is for this reason that the management primarily relies on its experience to establish designate a payback period.
Secondly, this method of investment appraisal ignores the timing of the cash flows. Failing to consider the time value of money has the undesired consequence of understating the true payback period (Baker & Powell, 2005, p.249). This period would be longer if the cash flows were discounted. Downward biases in a regular payback can also lead to accepting costs more than they are worth. Besides, projects with different patterns of cash flows may have the same payback period which is not a basis for deciding that they are equally viable in an economic sense.
Furthermore, the method ignores cash flows that occur after the payback period (Baker & Powell, 2005, p.248). This has the potential of accepting projects which are profitable only in the short term at the expense of those which may be very profitable in the long run.
In addition, this approach lacks any objective criterion which is consistent with the important goal of maximizing shareholder value. This is the direct consequence of the method’s potential to accept projects that do not contribute most to the maximization of shareholder wealth.
Lastly, the method only measures the speed of recovering initial investment as opposed to profitability. Critics charge that the decision rule in the payback period does not ask the right question. As opposed to how fast a project recovers its initial investment, the relevant issue should be how much it contributes to the value of a firm.
Accounting Rate of Return (ARR)
As the name suggests, this approach to investment appraisal compares the annual accounting profits to the initial investment. It is a ratio.
This can be illustrated with a hypothetical project with the following cash flows:
The example assumes that the incremental cash flows in Years 1-4 are the same as annual profits for the project.
| Project Year(t) 0 1 2 3 4 |
| Net Cash flow(£) -100,000 30,000 40,000 50,000 60,000
Cumulative NCF -100,000 -70,000 -30,000 20,000 80,000 |
Advantages
Using ARR as a method of investment appraisal allows for a comparison between different projects. In addition, showing the simple measure of profitability makes it easy for people to understand this method of appraisal.
Disadvantage
The only disadvantage with ARR is that it ignores the timing of the cash flows in the analysis. This is an omission is very vital information in the appraisal process.
Net Present Value (NPV)
Behind NPV as an investment appraisal technique is the recognition of the concept of time value of money. By this concept, one would prefer £ 1 today than having it in say 2 years time. Likewise, firms would be better off having cash inflows now than some time in the future. The present value of any cash flow is the value of that amount in today’s equivalents. Thus, an investor expecting £ 100,000 two years from now would be interested in knowing how much that amount is worth in today’s terms.
Where:
Future Value=the amount to be received in the future
i=expected return which is the rate of interest that the management uses for discounting the cash flow
n=is the number of years into the future before the given cash flow is received.
Assuming that the management in our example uses a rate of 10%, then the present Value of £100,000 to be received in two years is given as below.
The example above has only one cash flow in the second year, but the NPV procedure works even with multiple cash inflows and outflows. The NPV of a project is the sum of the present values of all its cash inflows and outflows (Baker & Powell, 2005, p.229).
Decision rules for NPV
With the NPV approach, the reference point for accepting or rejecting projects is zero. From a theoretical perspective, a firm should always accept a project where NPV=0. Such a project would have earned its required rate of return (Brealey, Myers & Allen, 2011, p.107). This decision rule applies to independent projects. The decision rule for mutually exclusive projects is to accept the project with the highest positive NPV.
Advantages of NPV
Using NPV comes with a number of strengths. For one, it is an objective basis of making decisions that maximize shareholder wealth (Maher, Stickney & Weil, 2008, p.276). This arises from the fact that NPV is a direct measure of a project’s benefit to shareholders in pounds.
Secondly, NPV fully accounts for time value of money. This is in addition to the consideration of all cash flows of the project. In contrast, the payback method only considers cash flows up to the payback period.
In addition, NPV has a relatively better assumption of reinvestment rate over the life of the project. There is always an implicit assumption under the NPV that the firm can reinvest all the project’s cash inflows over the life of the project. This is in contrast to another method called the internal rate of return (IRR) which implicitly assumes the reinvestment of the cash inflows at the project’s IRR over the lifespan.
Lastly, the accept-reject decision criterion under the NPV is theoretically superior given its founding on the effects on shareholder wealth.
Disadvantages of NPV
Despite its numerous merits, the NPV approach has two main disadvantages. For one, it is not possible to gauge the relative profitability of a project using the NPV approach. For example, a project with an NPV of £2,000 may be good if the initial investment was only £ 4,000. This may not be the case if the initial investment was actual £ 2,000,000.
Another disadvantage of NPV stems from the fact that some people find it difficult to understand. Managers normally prefer percentage returns as opposed to absolute pound returns.
Investment Appraisal Activity
Under the Payback Period
This approach advocates for projects that take the least amount of time to recover the investment. It is, therefore, necessary to calculate the Payback Period for all four machines to determine the most appropriate one to pick.
Machine 1
| Year | Cash flow(£) | Cumulative Cash flow(£) |
| 0 | -550,000 | -550,000 |
| 1 | 20,000 | -530,000 |
| 2 | 75,000 | -455,000 |
| 3 | 125,000 | -330,000 |
| 4 | 250,000 | -80,000 |
| 5 | 200,000 | 120,000 |
From the above table, only £80,000 of the initial investment remains unrecovered as at the end of Year 4. Assuming that the £ 200,000 received in year 5 is received evenly throughout the year, we can calculate the proportion of the year in which the £ 80,000 is received.
Machine 2
| Year | Cash Flow(£) | Cumulative Cash Flow(£) |
| 0 | -550,000 | -550,000 |
| 1 | 50,000 | -500,000 |
| 2 | 175,000 | -325,000 |
| 3 | 200,000 | -125,000 |
| 4 | 175,000 | 50,000 |
| 5 | 70,000 | 120,000 |
Only £ 125,000 is unrecovered by the end of Year 3. We, therefore, need to calculate the portion of Year 4 in which that amount is received assuming an even flow of that money during the year.
Machine 3
| Year | Cash Flow(£) | Cumulative Cash Flow(£) |
| 0 | -290,000 | -290,000 |
| 1 | 15,000 | -275,000 |
| 2 | 80,000 | -195,000 |
| 3 | 120,000 | -75,000 |
| 4 | 100,000 | 25,000 |
| 5 | 60,000 | 85,000 |
Machine 4
| Year | Cash Flow(£) | Cumulative Cash Flow(£) |
| 0 | -460,000 | -460,000 |
| 1 | 30,000 | -430,000 |
| 2 | 95,000 | -335,000 |
| 3 | 150,000 | -185,000 |
| 4 | 210,000 | 25,000 |
| 5 | 300,000 | 325,000 |
Using the Decision Criteria in the Payback Period, one would recommend Machine 2 because is has earliest Payback Period of 3.71 years.
Using Net Present Value Approach
Given the fact that the likely discount rate could vary from 4.5% to 6.0%, choosing a discount rate of 6.0% is the most appropriate. The decision criterion under NPV is to accept the project with the highest NPV.
Machine 1
| Year | Cash Flow(£) | Discount Factor (6%) | Present Value(£) |
| 0 | -550, 000 | 1.00 | -550,000 |
| 1 | 20, 000 | 0. 9433962 | 18,867.92 |
| 2 | 75, 000 | 0. 8899964 | 66,749.73 |
| 3 | 125, 000 | 0. 8396193 | 104,952.41 |
| 4 | 250, 000 | 0. 7920937 | 198,023.43 |
| 5 | 200, 000 | 0. 7472582 | 149,451.64 |
| Total | 120,000 | -11,954.87 |
Machine 2
| Year | Cash Flow(£) | Discount Factor (6%) | Present Value(£) |
| 0 | -550, 000 | 1.00 | -550,000 |
| 1 | 50, 000 | 0. 9433962 | 47,169.81 |
| 2 | 175, 000 | 0. 8899964 | 155,749.37 |
| 3 | 200, 000 | 0. 8396193 | 167,923.86 |
| 4 | 175, 000 | 0. 7920937 | 138,616.40 |
| 5 | 70, 000 | 0. 7472582 | 52,308.07 |
| Total | 120,000 | 11,767.51 |
Machine 3
| Year | Cash Flow(£) | Discount Factor (6%) | Present Value(£) |
| 0 | -290, 000 | 1.00 | -290,000 |
| 1 | 15, 000 | 0. 9433962 | 14,150.94 |
| 2 | 80, 000 | 0. 8899964 | 71,199.71 |
| 3 | 120, 000 | 0. 8396193 | 100,754.32 |
| 4 | 100, 000 | 0. 7920937 | 79,209.37 |
| 5 | 60, 000 | 0. 7472582 | 44,835.49 |
| Total | 85,000 | 20,149.83 |
Machine 4
| Year | Cash Flow(£) | Discount Factor (6%) | Present Value(£) |
| 0 | -460, 000 | 1.00 | -460,000 |
| 1 | 30, 000 | 0. 9433962 | 28,301.89 |
| 2 | 95, 000 | 0. 8899964 | 84,549.66 |
| 3 | 150, 000 | 0. 8396193 | 125,942.90 |
| 4 | 210, 000 | 0. 7920937 | 166,339.68 |
| 5 | 300, 000 | 0. 7472582 | 224,177.46 |
| Total | 325,000 | 169,311.59 |
The NPV approach would suggest that Machine 4 is the most preferable as it has the highest positive NPV. Given the superiority of NPV as an appraisal technique, I would recommend that the company go for Machine 4 despite the fact that the Payback Period gives a conflicting choice.
Advice to the Board on Other Factors to Consider
Much as the quantitative analysis above may have settled on Machine 4, there are other qualitative factors that should come into consideration on the final decision to settle on any of the four machines.
For example, possible legal challenges that relates to a given choice must be taken into account. Governmental regulations and laws may make it more difficult to use some machines. An example is laws relating to intellectual property rights like patents and copyrights.
The board must also consider the strategic consequences of the consumption of scarce raw materials when using any of the four machines. In addition, the possible relationships with important parties like trade unions should also be a factor.
References
Baker, H.K., & Powell, G.E. (2005). Understanding Financial Management: A Practical Guide. Garsington Road, Oxford: Blackwell Publishing.
Brealey, R.A., Myers, S.C., & Allen, F. (2011). Principles of Corporate Finance. Avenue of the Americas, New York: McGraw-Hill Irwin.
Maher, M.W., Stickney, C.P., & Weil, R.L. (2008).Managerial Accounting: An Introduction to Concepts, Methods and Uses (10th Edn.).Mason,OH:Thomson.
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