Capital Budgeting Techniques

Capital Budgeting Technique

MGMT-3004-04 Financial Management

Capital Budgeting Techniques

Capital budgeting is one of the most important decisions that face a financial manager. There are many techniques that they can use to facilitate the decision of whether a project or investment is worthy of consideration. The four that will be covered within this paper are Payback Rule, Profitability Index, IRR and NPV. Each method has its strength and weaknesses and they will be examined to determine which method is superior to the rest.

The first method to look at is Payback Rule. This rule is designed to show how long it will take to recover the cost of investment for the firm. This investment rule specifies a certain number of periods as a cutoff for determining whether to invest in a project. All investment projects where the initial investment cannot be recovered in specified cutoff period are unacceptable under this rule no matter what they provide past the cutoff. It is the easiest of all the methods to use and understand that will be reviewed. An example of this method is list in table 1. Now if we look at this table we find that if we use two periods as the cutoff then only Project B would be accepted for Project A does break even until year three. The problem with this method is that Project B breaks even but does not provide any income for the firm where Project A would in year three.

C0 C1 C2 C3 NPV at 10%

Project A -1000 800 150 250 39.06

Project B -2500 1200 1300 0 -334.71

Table 1

The next method to review is Profitability Index. The profitability index is defined as PI = -PV/C0. This method was ranked as next to the lowest in 2003 survey with only APV below it. (Financial Executive'S News, 2003, p. 2) This method is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a calculated ratio. (Investopedia, 2006) A ratio of 1.0 is the lowest suitable measure on the index. If the value is lower than 1.0 it would indicate that the project's Present Value (PV) is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project. An advantage of this technique is that it attempts to adjust for capital rationing. A major disadvantage is if projects are mutually exclusive, and we cannot accept fractions of projects, this can lead to a scaling problem with this method. An example of this method is in table 2.

C0 PV(C1,..,Cn) PI NPV

Project A 200 240 1.2 40

Project B 1000 1100 1.1 100

Table 2

The next method is Internal Rate of Return (IRR) and it has been the de facto standard of business for many years. It was ranked the tops in the 2003 survey mentioned earlier beating the second place contender by just 2 percentage points. IRR can be defined as any discount rate that results in a net present value of zero. It is usually interpreted as the expected return generated by the investment over a periods of time. The advantage of this method is that is very easy to understand for management because it is expressed in percentages verses dollar amount as other methods. Another benefit of IRR is that it can be calculated without having to estimate the cost of capital.

There are many draw backs to IIR as an investment decision tool. When calculated, IRR should not be used to rate mutually exclusive projects, but used to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project. IRR should not be used for projects that start with an initial positive cash inflow. An example of this is if a customer makes a deposit before a specialty vehicle, such as a large crane, is built. This example results in a single positive cash flow followed by a series of negative cash flows. In this case the usual IRR decision rule needs to be reversed. The other case where IRR fails is if there are multiple sign changes in the series of cash flows. The way to calculate the IRR is to do multiple IRRs for a single project, so that the IRR decision rule may be impossible to implement. The most critical shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. "However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; therefore, the actual rate of return is almost certainly going to be lower". (Wikipedia, 2006)

Table three shows an example for each of these problems with calculations for IRR. When one looks at Projects 1 it is accepted only if the rate is lower than 13.96 percent where as with Project 2 is would have to higher than 13.96 percent to be accepted. Problem 3 is where the problem arises with IRR, when one looks at Figure 1 one can see that it does not follow and investment or borrowing as other two examples but goes down then up. The conclusion for this project is for it be accepted if the discount rate is less than 8.80 or greater than 19.22 percent.

Year 0 1 2 3 4 5 IRR

Project 1 -1000 200 200 300 350 500 13.96%

Project 2 1000 -200 -200 -300 -350 -500 13.96%

Project 3 400 0 11000 -8800 -26250 24200 8.80%, 19.22%

Table 3

Figure 1

The