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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