Capital Budgeting Techniques That Drive Decisions
Companies make important decisions around the clock. From big-ticket projects with wide-reaching implications to one-off undertakings, management is constantly faced with deciding among options that all seem equally viable. You may have wondered how these critical decisions are put together? The answer lies in a process called capital budgeting.
Capital budgeting is the act of allocating scarce capital across available projects and investments. We can dissect this definition further.
“The act of allocating” highlights how this is a decision implemented by decision-makers. The quantitative techniques are accessible to everyone but, ultimately, someone has to make the call.
“Scarce capital” points out the limited funds companies have at their disposal. Regardless of size, every business will have finite resources. Allocating them in the most optimal way is the essence of capital budgeting.
And “available projects and investments” underlines the fact that there are often multiple options on the table. The challenge, particularly when choosing projects with different traits, is determining which ones are worth pursuing. Moreover, initiatives can be mutually exclusive — going after one precludes you from investigating the other — or independent, which introduces another layer of complexity to the decision.
Fortunately, capital budgeting operates a collection of techniques to simplify the process.
There are many ways to assess and compare the viability of projects, but the main ones used in practice include the Payback Period (PP), Net Present Value (NPV), and Internal Rate of Return (IRR). It is also worth mentioning alternative techniques like the Discounted Payback Period, Profitability Index (PI), and the Accounting Rate of Return (ARR).
The Payback Period defines the time it takes to recover (i.e., get back) your initial investment on a project.
If you spend $100K on a project that yields $20K each year, then your Payback Period is 5 years or $100K divided by $20K per year.
This is arguably the most straightforward and intuitive capital budgeting technique. Indeed, its main advantage is that it is easily understood and applied. Stakeholders across the company will know what its insights mean right away.
Unfortunately, the Payback Period fails as a project evaluation tool when the expected cash flows fluctuate. Consider two projects, A and B, and assume the following:
- The initial investment for both A and B is $100K
- Project A yields $100K in year 1
- Project B yields $50K in year 2
Using the Payback Period method, project A seems to be the superior choice with a PP of one year. But this reasoning completely ignores the expected cash flows after the first year.
The Payback Period also fails to account for the Time Value of Money. Although, the Discounted Payback Period addresses this concern by discounting the expected cash flows as a preliminary step to estimating the time needed to recover an investment.
Perhaps the most widely used technique for evaluating capital projects is Net Present Value. On a fundamental level, NPV tells us the dollar value a project adds to the business, net of what we expect to spend on it. If we expect to spend $100K on a project that will generate a one-time cash inflow of $200K next year, then we can follow the ensuing steps:
Step 1: Estimate the opportunity cost of capital. HBR provides a refresher on the cost of capital.
Step 2: Determine the present value — today’s equivalent value — of next year’s $200K. Assuming a cost of capital of 12%, we can approximate next year’s $200K to be around $179K today. In other words, we would be indifferent as to getting $179K today or $200K next year.
Step 3: Calculate the net amount received. If we spend $100K today for a project that effectively gives $179K in today’s value, then the project is estimated to be worth $79K, or $179K minus $100K.
The $79K in our example is the NPV of the proposed project. Consequently, this capital budgeting tool is also easily interpreted — positive NPV projects add value while negative NPV projects diminish it.
While NPV is more computationally complex than PP, modern spreadsheets like Microsoft Excel, Google Sheets, and LibreOffice Calc make our lives easier by having the functionality built in. You can find more information on how to calculate NPV in Excel or take a look at our NPV Excel template for a deeper dive into NPV computations.
Alternatively, some managers and executives prefer the likeness of an IRR to the cost of capital. Both are expressed as rates, so comparing them is easy.
IRR is closely tied to NPV. Specifically, IRR is the discount rate that results in an NPV of zero. Therefore, the decision to accept or reject a project depends on whether IRR is greater than the cost of capital or not.
Despite its popularity, there are drawbacks to using IRR you should be aware of. For one, IRR is difficult to calculate freehand. Also, IRR doesn’t work for projects with unconventional cash flows, or cash flows that change direction more than once.
Nevertheless, IRR is a tool every financial analyst should have, so it helps to know the advantages and disadvantages of IRR.
Complex solutions aren’t necessarily better, and the same logic applies to capital budgeting decisions. First, we must consider the project’s cash flow and understand if it contrasts conventional cash flows. Based on our findings, we can then recommend the capital budgeting technique to use.
Conventional versus unconventional cash flows relate to the change in direction we can expect from our cash flows. When cash flows change direction once (i.e., from cash outflows to cash inflows), then the project’s cash flows are labeled as conventional.
Apart from the change in direction, we also have to be mindful of differences in cash flow timing. The following table demonstrates how timing differences can lead to conflicting results even if every option has conventional cash flows.
When comparing projects with complicated cash flows, the recommended approach is NPV. IRR is justifiable, too, assuming its limitations are managed.
But for comparing projects with equal time horizons, similar sizes, and conventional cash flows, the Payback Period and related tools come in handy. These tools are quick to figure out and their insights are easy to share.
Interestingly, NPV, IRR, and PP all yield conflicting results on the available projects identified in the table above. NPV recommends Project A, IRR suggests Project B, and PP points to Project C. So how would you choose the right one?
Questions like this are common during the practical stage of job interviews in the financial and business sectors. To learn how to untangle the thornier issues of capital budgeting, corporate governance, working capital, and other related topics, sign onto our comprehensive Corporate Finance Course.
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