Capital Budgeting
Capital budgeting-meaning and types, time value of money, typical cash inflows and
outflows, recovery of original investment, IRR, NPV, uncertain cash flow, ranking of
investment projects, PBP, post audit of investment project.
Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the
best returns on investment. An organization is often faced with the challenges of selecting
between two projects/investments or the buy vs. replace decision.
There are several capital budgeting analysis methods that can be used to determine the economic
feasibility of a capital investment. They include the Payback Period, Discounted Payment Period,
Net Present Value, Portability Index, Internal Rate of Return, and Modified Internal Rate of
Return.
Payback Period: The payback period disregards the time value of money. It is determined by
counting the number of years it takes to recover the funds invested. For example, if it takes five
years to recover the cost of an investment, the payback period is five years. Some analysts favour
the payback method for its simplicity.
Discounted Payment Period: The Discount Payment Period (DPP) refers to the period of time
in which a payment on a purchase can be made for a discount incentive. A DDP can lead to
advantages for both sides of the transaction. On one side, if the buyer makes the payment during
the DDP, the buyer saves money and drives down costs.
Net Present Value: What Is Net Present Value (NPV)?
Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyze the profitability of a projected investment or project. NPV is the
result of calculations used to find today’s value of a future stream of payments.
What Net Present Value Can Tell You
NPV accounts for the time value of money and can be used to compare similar investment
alternatives. The NPV relies on a discount rate that may be derived from the cost of the capital
required to invest, and any project or investment with a negative NPV should be avoided. One
important drawback of NPV analysis is that it makes assumptions about future events that may
not be reliable.
NPV looks to assess the profitability of a given investment on the basis that a dollar in the future
is not worth the same as a dollar today. Money loses value over time due to inflation. However, a
dollar today can be invested and earn a return, making its future value possibly higher than a
dollar received at the same point in the future.
NPV seeks to determine the present value of an investment's future cash flows above the
investment's initial cost. The discount rate element of the NPV formula discounts the future cash
flows to the present-day value. If subtracting the initial cost of the investment from the sum of
the cash flows in the present day is positive, then the investment is worthwhile.
For example, an investor could receive $100 today or a year from now. Most investors would not
be willing to postpone receiving $100 today. However, what if an investor could choose to
receive $100 today or $105 in one year? The 5% rate of return (RoR) for waiting one year might
be worthwhile for an investor unless another investment could yield a rate greater than 5% over
the same period.
If an investor knew they could earn 8% from a relatively safe investment over the next year, they
would choose to receive $100 today and not the $105 in a year, with the 5% rate of return. In this
case, 8% would be the discount rate.
Positive vs. Negative NPV
A positive NPV indicates that the projected earnings generated by a project or investment—in
present dollars—exceeds the anticipated costs, also in present dollars. It is assumed that an
investment with a positive NPV will be profitable.
An investment with a negative NPV will result in a net loss. This concept is the basis for the Net
Present Value Rule, which dictates that only investments with positive NPV values should be
considered.
Calculating Net Present Value
Money in the present is worth more than the same amount in the future due to inflation and
possible earnings from alternative investments that could be made during the intervening time. In
other words, a dollar earned in the future won’t be worth as much as one earned in the
present. The discount rate element of the NPV formula is a way to account for this.
For example, assume that an investor could choose a $100 payment today or in a year. A rational
investor would not be willing to postpone payment. However, what if an investor could choose
to receive $100 today or $105 in a year? If the payer was reliable, that extra 5% may be worth
the wait, but only if there wasn’t anything else the investors could do with the $100 that would
earn more than 5%.
An investor might be willing to wait a year to earn an extra 5%, but that may not be acceptable
for all investors. In this case, the 5% is the discount rate, which will vary depending on the
investor. If an investor knew they could earn 8% from a relatively safe investment over the next
year, they would not be willing to postpone payment for 5%. In this case, the investor’s discount
rate is 8%.
A company may determine the discount rate using the expected return of other projects with a
similar level of risk or the cost of borrowing the money needed to finance the project. For
example, a company may avoid a project that is expected to return 10% per year if it costs 12%
to finance the project or an alternative project is expected to return 14% per year.
Imagine a company can invest in equipment that will cost $1,000,000 and is expected to generate
$25,000 a month in revenue for five years. The company has the capital available for the
equipment and could alternatively invest it in the stock market for an expected return of 8% per
year. The managers feel that buying the equipment or investing in the stock market are similar
risks.
Limitations of Net Present Value
Gauging an investment’s profitability with NPV relies heavily on assumptions and estimates, so
there can be substantial room for error. Estimated factors include investment costs, discount rate,
and projected returns. A project may often require unforeseen expenditures to get off the ground
or may require additional expenditures at the project’s end.
Net Present Value vs. Payback Period
The payback period, or “payback method,” is a simpler alternative to NPV. The payback method
calculates how long it will take for the original investment to be repaid. A drawback is that this
method fails to account for the time value of money. For this reason, payback periods calculated
for longer investments have a greater potential for inaccuracy.
Moreover, the payback period is strictly limited to the amount of time required to earn back
initial investment costs. It is possible that the investment’s rate of return could experience sharp
movements. Comparisons using payback periods do not account for the long-term profitability of
alternative investments.
NPV vs. Internal Rate of Return (IRR)
The internal rate of return (IRR) is very similar to NPV except that the discount rate is the rate
that reduces the NPV of an investment to zero. This method is used to compare projects with
different lifespans or amounts of required capital.
For example, IRR could be used to compare the anticipated profitability of a three-year project
that requires a $50,000 investment with that of a 10-year project that requires a $200,000
investment. Although the IRR is useful, it is usually considered inferior to NPV because it makes
too many assumptions about reinvestment risk and capital allocation.
What Is a Good NPV?
In theory, an NPV is “good” if it is greater than zero. After all, the NPV calculation already takes
into account factors such as the investor’s cost of capital, opportunity cost, and risk tolerance
through the discount rate. And the future cash flows of the project, together with the time value
of money, are also captured. Therefore, even an NPV of $1 should theoretically qualify as
“good.” In practice, however, many investors will insist on certain NPV thresholds, such as
$10,000 or greater, to provide themselves with an additional margin of safety.
Why Are Future Cash Flows Discounted?
NPV uses discounted cash flows due to the time value of money (TMV). The time value of
money is the concept that money you have now is worth more than the identical sum in the
future due to its potential earning capacity through investment and other factors such as inflation
expectations. The rate used to account for time, or the discount rate, will depend on the type of
analysis undertaken. Individuals should use the opportunity cost of putting their money to work
elsewhere as an appropriate discount rate—simply put, it’s the rate of return the investor could
earn in the marketplace on an investment of comparable size and risk.
Profitability Index: The profitability index (PI) is a measure of a project's or investment's
attractiveness. The PI is calculated by dividing the present value of future expected cash flows by
the initial investment amount in the project.
Internal Rate of Return:
Modified Internal Rate of Return:
