Capital Budgeting 101: Get the Basics

capital budgetingEmbarking on a new business venture can be one of the most difficult endeavors of your lifetime.  Every business owner needs to know the basics of capital budgeting to get through the ups and downs.  Obtaining the necessary startup capital from reluctant investors is no walk in the park, either.

Anyone from entrepreneurs to existing business owners know that knowledge is power in running any company.  The more you know about where your money goes and how much it benefits your bottom line, the more likely you are to generate successful returns on your investments.  Additionally, the more you know about this area, the less likely you are to hire outside help, which in turns means more to invest!

What is Capital Budgeting?

According to our friends at Wikipedia, capital budgeting is the planning of long-term corporate financial projects relating to investments funded through and affecting the firm’s capital structure. Management must allocate the firm’s limited resources between competing opportunities (projects), which is one of the main focuses of capital budgeting. Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital. Investments should be made on the basis of value-added to the future of the corporation. Capital budgeting projects may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions. When no such value can be added through the capital budgeting process and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company’s stock through a share buyback program.

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Popular Capital Budgeting Techniques

A variety of measures have evolved over time to analyze capital budgeting requests.  The better methods use time value of money concepts.  Older methods, like the payback period, have the deficiency of not using time value techniques and will eventually fall by the wayside and be replaced in companies by the newer, superior methods of evaluation.

A capital budgeting analysis conducts a test to see if the benefits (i.e., cash inflows) are large enough to repay the company for three things:  (1) the cost of the asset, (2) the cost of financing the asset (e.g., interest, etc.), and (3) a rate of return (called a risk premium) that compensates the company for potential errors made when estimating cash flows that will occur in the distant future.

For a thorough introduction to the various capital markets, check out this Capital Market Roadmap.

Let’s take a look at the most popular techniques for analyzing a capital budgeting proposal.

1) Payback Period

Alright, let’s get this out of the way up front: the Payback Period isn’t a very good method. After all, it doesn’t use the time value of money principle, making it the weakest of the methods that we will discuss here. However, it is still used by a large number of companies, so we’ll include it in our list of popular methods.

What is the payback period? By definition, it is the length of time that it takes to recover your investment. Capital and Revenue Expenditure 101: Ways to Spend can help with any questions you may have about your investments.

For example, to recover $30,000 at the rate of $10,000 per year would take 3.0 years.  Companies that use this method will set some arbitrary payback period for all capital budgeting projects, such as a rule that only projects with a payback period of 2.5 years or less will be accepted.  (At a payback period of 3 years in the example above, that project would be rejected.)

The payback period method is decreasing in use every year and doesn’t deserve extensive coverage here.

2) Net Present Value

Using a minimum rate of return known as the hurdle rate, the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows.  A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC)

NPV = PVB – PVC

By using the hurdle rate as the discount rate, we are conducting a test to see if the project is expected to earn our minimum desired rate of return.  Here are our decision rules:

  • If the NPV is:Benefits vs. Costs: Should we expect to earn at least our minimum rate of return?            Accept the investment?

Remember that we said above that the purpose of the capital budgeting analysis is to see if the project’s benefits are large enough to repay the company for (1) the asset’s cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates.

  • Therefore, if the NPV is:

Positive: the benefits are more than large enough to repay the company for (1) the asset’s cost, (2) the cost of financing the project, and (3) a rate of return that adequately compensates the company for the risk found in the cash flow estimates.

Zero: the benefits are barely enough to cover all three but you are at breakeven – no profit and no loss, and therefore you would be indifferent about accepting the project.

Negative: the benefits are not large enough to cover all three, and therefore the project should be rejected.

3) Internal Rate of Return

The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the investment.  Technically, it is the discount rate that causes the present value of the benefits to equal the present value of the costs.  According to surveys of businesses, the IRR method is actually the most commonly used method for evaluating capital budgeting proposals.  This is probably because the IRR is a very easy number to understand because it can be compared easily to the expected return on other types of investments (savings accounts, bonds, etc.). If the internal rate of return is greater than the project’s minimum rate of return, we would tend to accept the project.

The calculation of the IRR, however, cannot be determined using a formula; it must be determined using a trial-and-error technique.

4) Modified IRR

The Modified Internal Rate of Return (MIRR) is an attempt to overcome the above two deficiencies in the IRR method.  The person conducting the analysis can choose whatever rate he or she wants for investing the cash inflows for the remainder of the project’s life.

For example, if the analyst chooses to use the hurdle rate for reinvestment purposes, the MIRR technique calculates the present value of the cash outflows (i.e., the PVC), the future value of the cash inflows (to the end of the project’s life), and then solves for the discount rate that will equate the PVC and the future value of the benefits.

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