Capital Budgeting

All of us, at one time or another, have had to deal with either preparing or following a budget. In fact, many households manage their financial affairs through a budget. Businesses do the same thing through what is known as capital budgeting.

The process of capital budgeting is vital to any responsible, well managed business. If that business is public and owned by public shareholders, the budgeting process becomes more crucial, since shareholders can hold management accountable for accepting unprofitable projects that can have the effect of destroying shareholder value.

Capital budgeting is a step by step process that businesses use to determine the merits of an investment project. The decision of whether to accept or deny an investment project as part of a company's growth initiatives, involves determining the investment rate of return that such a project will generate. However, what rate of return is deemed acceptable or unacceptable is influenced by other factors that are specific to the company as well as the project. For example, a social or charitable project is often not approved based on rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.

Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project, without understanding the risks and returns involved, would be held as irresponsible by its owners or shareholders. Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are that the business will have little chance of surviving in the competitive marketplace.

Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project.

Capital budgeting is also vital to a business because it creates a structured step by step process that enables a company to:

Develop and formulate long-term strategic goals – the ability to set long-term goals is essential to the growth and prosperity of any business. The ability to appraise/value investment projects via capital budgeting creates a framework for businesses to plan out future long-term direction.

Seek out new investment projects – knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry.

Estimate and forecast future cash flows – future cash flows are what create value for businesses overtime. Capital budgeting enables executives to take a potential project and estimate its future cash flows, which then helps determine if such a project should be accepted.

Facilitate the transfer of information – from the time that a project starts off as an idea to the time it is accepted or rejected, numerous decisions have to be made at various levels of authority. The capital budgeting process facilitates the transfer of information to the appropriate decision makers within a company.

Monitoring and Control of Expenditures – by definition a budget carefully identifies the necessary expenditures and R&D required for an investment project. Since a good project can turn bad if expenditures aren't carefully controlled or monitored, this step is a crucial benefit of the capital budgeting process.

Creation of Decision – when a capital budgeting process is in place, a company is then able to create a set of decision rules that can categorize which projects are acceptable and which projects are unacceptable. The result is a more efficiently run business that is better equipped to quickly ascertain whether or not to proceed further with a project or shut it down early in the process, thereby saving a company both time and money.

Unlike other business decisions that involve a singular aspect of a business, a capital budgeting decision involves two important decisions at once: a financial decision and an investment decision. By taking on a project, the business has agreed to make a financial commitment to a project, and that involves its own set of risks. Projects can run into delays, cost overruns and regulatory restrictions that can all delay or increase the projected cost of the project.

In addition to a financial decision, a company is also making an investment in its future direction and growth that will likely have an influence on future projects that the company considers and evaluates. So to make a capital investment decision only from the perspective of either a financial or investment decisions can pose serious limitations on the success of the project.

In December 2009 ExxonMobil, the world's largest oil company, announced that it was acquiring XTO Resources, one of the largest natural gas companies in the U.S. for $41 billion. That acquisition was a capital budgeting decision, one in which ExxonMobil made a huge financial commitment. But in addition, ExxonMobil was making a significant investment decision in natural gas and essentially positioning the company to also focus on growth opportunities in the natural gas arena. That acquisition alone will have a profound effect on future projects that ExxonMobil considers and evaluates for many years to come.

The significance of these dual decisions is profound for companies. Executives have been known to lose jobs over poor investment decisions. One can say that running a business is nothing more than a constant exercise in capital budgeting decisions. Understanding that both a financial and investment decision is being made is paramount to making successful capital investment decisions.

In sum, the capital budgeting process is the tool by which a company administers its investmentopportunities in additional fixed assets by evaluating the cash inflows and outflows of such opportunities. Once such opportunities have been identified or selected, management is then tasked with evaluating whether or not the project is desirable.

Depending on the business, the competitive environment and industry forces, companies will certainly have some unique desirability criteria. As noted earlier, it's very crucial to remember that the capital budgeting process involves two sets of decisions, investment decisions and financial decisions; given the unique business and market environments that exist at the time, each decision may not initially be seen as worthwhile individually, but could be worthwhile if both were to be undertaken.

Consider an example involving the coffee chain Starbucks. On Nov. 14, 2012, Starbucks announced its intent to acquire Teavana, a high-end specialty retailer of tea, for $620 million. The offer price for Teavana represented a 50% premium over the then market value of Teavana. Based on the acquisition price, Starbucks would paying over 36 times earnings for Teavana. Looking at this capital investment today, one can suggest that the financial decision – paying $620 million for a company that generated $167 and $18 million in sales and profits in 2011 – was not a desirable one for Starbucks.

On the other hand, from an investment perspective, Starbucks is paying $620 million for ownership of a fast-growing, leading tea retailer. Teavana gives Starbucks direct access to the fast-growing underpenetrated tea market. In addition, Teavana instantly gives Starbucks approximately 200 high-traffic retail locations and, more importantly, a very visible, high-quality tea brand to complement its coffee offerings. Had Starbucks merely evaluated Teavana from a purely financial perspective, the decision would have ignored that highly-valuable benefit of combining the most well-known coffee brand with the highest-quality tea brand.

Generally speaking however, businesses will consider the following questions when evaluating whether or not a project is desirable and should be pursued.

What Will the Project Cost?

This is the first and most basic question a company must answer before pursuing a project. Identifying the cost, which includes the actual purchase price of the assets along with any future investment costs, determines whether or not the business can afford to take on such a project.

How Long Will It Take to Re-coup the Investment?

Once the costs have been identified, management must determine the cash return on that investment. An affordable project that has little chance of recouping the initial investment, in a reasonable period of time, would likely be rejected unless there were some unique strategic decisions involved. For Starbucks, it is counting on the fact that when Teavana's brand is matched with Starbucks vast distribution network, the rapid growth in sales of tea and tea related projects will deliver tremendous cash flows to Starbucks. Of course, there is no guarantee that management's forecast will prove accurate or correct; nevertheless, forecasting future cash inflows and outflows are a vital exercise in the capital budgeting process.

Mutually Exclusive or Independent?

All investment projects are considered to be mutually exclusive or independent. An independent project is one where the decision to accept or reject the project has no effect on any other projects being considered by the company. The cash flows of an independent project have no effect on the cash flows of other projects or divisions of the business. For example the decision to replace a company's computer system would be considered independent of a decision to build a new factory.

A mutually-exclusive project is one where acceptance of such a project will have an effect on the acceptance of another project. In mutually exclusive projects, the cash flows of one project can have an impact on the cash flows of another. Most business investment decisions fall into this category. Starbucks decision to buy Teavana will most certainly have a profound effect on the future cash flows of the coffee business as well as influence the decision making process of other future projects undertaken by Starbucks.

Once projects have been identified, management then begins the financial process of determining whether or not the project should be pursued. The three common capital budgeting decision tools are the payback period, net present value (NPV) method and the internal rate of return (IRR) method.

Payback Period

The payback period is the most basic and simple decision tool. With this method, you are basically determining how long it will take to pay back the initial investment that is required to undergo a project. In order to calculate this, you would take the total cost of the project and divide it by how much cash inflow you expect to receive each year; this will give you the total number of years or the payback period. For example, if you are considering buying a gas station that is selling for $100,000 and that gas station produces cash flows of $20,000 a year, the payback period is five years.

As you might surmise, the payback period is probably best served when dealing with small and simple investment projects. This simplicity should not be interpreted as ineffective, however. If the business is generating healthy levels of cash flow that allow a project to recoup its investment in a few short years, the payback period can be a highly effective and efficient way to evaluate a project. When dealing with mutually exclusive projects, the project with the shorter payback period should be selected.

Net Present Value (NPV)

The net present value decision tool is a more common and more effective process of evaluating a project. Perform a net present value calculation essentially requires calculating the difference between the project cost (cash outflows) and cash flows generated by that project (cash inflows). The NPV tool is effective because it uses discounted cash flow analysis, where future cash flows are discounted at a discount rate to compensate for the uncertainty of those future cash flows. The term "present value" in NPV refers to the fact that cash flows earned in the future are not worth as much as cash flows today. Discounting those future cash flows back to the present creates an apples to apples comparison between the cash flows. The difference provides you with the net present value.

The general rule of the NPV method is that independent projects are accepted when NPV is positive and rejected when NPV is negative. In the case of mutually exclusive projects, the project with the highest NPV should be accepted.

Internal Rate of Return (IRR)

The internal rate of return is a discount rate that is commonly used to determine how much of a return an investor can expect to realize from a particular project. Strictly defined, the internal rate of return is the discount rate that occurs when a project is break even, or when the NPV equals 0. Here, the decision rule is simple: choose the project where the IRR is higher than the cost of financing. In other words, if your cost of capital is 5%, you don't accept projects unless the IRR is greater than 5%. The greater the difference between the financing cost and the IRR, the more attractive the project becomes.

The IRR decision rule is straightforward when it comes to independent projects; however, the IRR rule in mutually-exclusive projects can be tricky. It's possible that two mutually exclusive projects can have conflicting IRRs and NPVs, meaning that one project has lower IRR but higher NPV than another project. These issues can arise when initial investments between two projects are not equal. Despite the issues with IRR, it is still a very useful metric utilized by businesses. Businesses often tend to value percentages more than numbers (i.e., an IRR of 30% versus an NPV of $1,000,000 intuitively sounds much more meaningful and effective), as percentages are more impactful in measuring investment success. Capital budgeting decision tools, like any other business formula, are certainly not perfect barometers, but IRR is a highly-effective concept that serves its purpose in the investment decision making process.

This tutorial will conclude with some basic, yet illustrative examples of the capital budgetingprocess at work.

Example 1: Payback Period

Assume that two gas stations are for sale with the following cash flows:

According to the payback period, when given the choice between two mutually exclusive projects, Gas Station B should be selected. Although both gas stations cost the same, Gas Station B has a payback period of one year, whereas Gas Station A will payback in roughly one and half years. Payback analysis is common to everyone in investment decisions, an example being the purchase of a hybrid car.

Example 2: Net Present Value Method

As was mentioned earlier, the payback period is a very basic capital budgeting decision tool that ignores the timing of cash flows. Since most capital investment projects have a life span of many years, a shorter payback period may not necessarily be the best project.

Consider the gas station example above under the NPV method, and a discount rate of 10%:

NPVgas station A = $100,000/(1+.10)2 - $50,000 = $32,644

NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10)2 - $50,000 = $16,115

In our gas station example, the net present value tool illustrates the limitations of the payback period. Under the payback period, the decision would have been to pick gas station B because it had the shorter payback period. Under the NPV criteria, however, the decision favors gas station A, as it has the higher net present value. In this particular case, the NPV of gas station A is more than twice that of gas station B, which implies that gas station A is a vastly better investment project to undertake.

In the real world, however, sometimes managers will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods. For example, suppose the NPV of gas station A was only slightly higher than that of B, yet the buyer was worried about meeting his financial obligations in year one. In that case, the choice may be made to take on the project with the quicker upfront cash flows even it means a slightly lower return. When might something like this occur? It could be that the buyer had to borrow a majority of the purchase price and really had a desire to pay back the loan sooner, rather than later, to save on interest expense. In that case, a quicker payback period may be more desirable than a slightly higher net present value project.

Do keep in mind, however, that all capital projects, in the case of for-profit enterprises, should be made in the context of creating long-term shareholder value. In our above example, gas station A with the higher NPV creates significantly more shareholder value than does gas station B. So even if the decision was made based on a quicker payback period, the project with greatest net present value would be the one that maximizes shareholder value. Generally speaking, accepting the project with the lower net present value would be destroying shareholder value.

Example 3 – Internal Rate of Return

The internal rate of return (IRR) method can perhaps be the more complicated and subjective of the three capital budgeting decision tools. Similar to the NPV, the IRR accounts for the time value of money. It is useful here to repeat the definition of the IRR:

The IRR of any project is the rate of return that sets the NPV of a project zero.

Since the general NPV rule is to only pick projects with an NPV greater than zero with the highest net present value, the internal rate of return, by definition, is the breakeven interest rate. In other words, the IRR decision criteria conceptually obvious:

Choose projects with an IRR that is greater than the cost of financing

This rule is easy to understand: if your cost of capital is 10%, projects with an internal rate of return of 8% would destroy value, while projects with an internal rate of return of 15% with increase value.

While it's conceptually simple to understand the internal rate of return process, calculating IRR can be a bit tricky. The calculation of a project's IRR is essentially a trial and error one. Consider the following example of a project with the following cash flows:

There is no simple formula to calculate the IRR. It's either done by trial and error or a financialcalculator. Remember, however, that the IRR is that rate where NPV is equal to zero, the equation would be set up like this:

CF0 + CF1/(1+IRR) + CF2/(1+IRR)2 + CF3/(1+IRR)3 = 0, or

-$1,000+ $100/(1+IRR) + $600/(1+IRR)2 + $800/(1+IRR)3 = 0

Believe or not, from here the next step is to guess a number for IRR, plug in and see if it equals zero.

When IRR = 20%, or .20, the result is a number greater than zero (you can try it yourself, just enter "0.20" in place of "IRR." Performing a trial and error calculation here would be too cumbersome but it's very simple and good practice, to try it yourself).

Thus 20% is too big a number. The next step would be to try a lower number.

When IRR = 17%, the NPV is less than zero, so that IRR is too low.

The IRR of this particular project is 18.1%. That is the interest where the NPV of the above project is zero. Plug it in and you should get zero or an insignificantly lower number that equates to zero.

Thus, if the cost of financing the above the project is below 18.1%, the project creates value under the IRR calculation; if the cost of financing is greater than 18.1%, the project will destroy value.

Just as is the case with the payback method and NPV, the IRR decision will not always agree with the NPV decision in mutually-exclusive projects. Again, this has to do with initial cash flow outlay and timing of future cash flows. However, in the end, despite the its flaws, percentages are more intuitive and useful in business, thus rendering value to the IRR method.

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