Finance Essentials: Capital Budgeting Made Simple

What is Capital Budgeting
It is the process of making a decision either by accepting or rejecting a project. This involves determining the long term value, assessing cash inflows and outlays, generating a target benchmark, and accounting for all opportunities.

The Capital Budgeting Process and Basic Principles 
The Budgeting Process has four main steps that we should consider. They are the following:
(1) Generating Ideas, which is the most important step in the process.
(2) Analyzing individual prospects by gathering information to forecast cash flows and evaluating profitability.
(3) Planning the capital budget.
(4) Monitoring and post-auditing, by reviewing actual results vs. predicted results. 

Basic Principles of Capital Budgeting include the following: 
(1) Decisions are based on cash flows; 
(2) Timing of cash flows are crucial; 
(3) Cash flows are based on opportunity costs;
(4) Cash flows are analyzed on an after-tax basis. In relation to taxes, taxable interest would reduce cost of capital.
(5) Financing costs are ignored because such costs are reflected in the required rate of return (discount rate). Including financing costs in the cash flows and in the discount rate results in double counting.
(6) Cost of capital is the rate of return that suppliers require as compensation for their contribution to capital; if suppliers believe the opportunity costs of funds can earn a higher return elsewhere, they would decide to not invest. Weighted Average Cost of Capital (WACC) is referred as the Marginal Cost of Capital (MCC) because it is the cost the company incurs. Formula for WACC = wdrd(1-T)+ wprp+were; where d is debt, p is preferred stock, e is equity, and w is weight relative to the capital structure. 
(6) Cash flows does not account net income - In the most basic form, the cash flow statement shows how much cash comes in and leaves a company. The statement strips out the accrual accounting requirement from the income statement and only shows cash exchanges (non-cash revenues or expenses are shown in the income statement).

Important concepts to be aware of include: 
(1) Sunk Costs are costs already incurred and do not affect future cash flows. They are not recognized as part of the project’s Net Present Value.
(2) Incremental cash flows are realized because of a decision: For example, incremental cash flows result from a decision minus cash flows without a decision.
(3) Externalities are effects of an investment that are outside the scope of the investment itself. For instance, cannibalization is one externality that occurs when an investment takes customers and sales away from another source of revenue. This should be recognized in the analysis. 
(4) Conventional vs. Non-Conventional cash flows - Conventional cash flows is a pattern of an initial cash outlay following a series of inflows. Unconventional cash flows do not necessarily have a series of continual inflows after the initial cash outlay. 
(5)  Independent vs. Mutually Exclusive projects – Mutually exclusive projects compete directly with one another. One project is not influenced or caused by another independent project, and such projects may not occur at the same time. Conversely, independent projects may occur at the same time.
(6) Project sequencing - Projects are sequenced through time so investing in a project creates the option to invest in future projects. If the result of the first project is not favorable, you do not invest in a second project. 
(7) Unlimited funds vs. capital rationing - Unlimited funds environment assumes that the company can raise the capital it wants, for all profitable projects, simply by paying the required rate of return. Capital rationing exists when the company has a fixed amount of funds to invest in.
 
Investment Decision Criteria
(1) Net Present Value (“NPV”) of an investment is the sum of all present values of its cash inflows minus the present value of its cash outlays. If NPV is greater than zero, then we should invest in the project. If NPV is less than zero, than we should not invest in the project. Determining the appropriate discount rate is also a critical part of the NPV calculation.
(2) Internal Rate of Return (“IRR”) is the discount rate that makes the present value of the future after tax cash flows equal the investment outlay. If the projected rate of return is greater than the project’s IRR, then we should invest in a project.
(3) Payback Period (PBP) is the number of years required to recover an original investment. Limitations are that it doesn’t account for the time value of money and it ignores future cash flows which can be negative. Typically, negative NPV would not have a discounted payback period, as it would have never recovered the initial investment. Payback Period = years + (Remaining Payback $/Cash Flow of that current year).
(4) Average Accounting Rate of Return (AAR) = Average net income/Average book value. Advantages include that it is easy to understand, however, disadvantages includes that it is based on accounting numbers and not forward looking cash flows, it does not account for the time value of money, and there is not a conceptual cutoff for the AAR that distinguishes between profitable and non-profitable companies. 
(5) Profitability Index = 1 + (NPV/Initial Investment). It indicates the value you are receiving for one unit of currency invested. Rule of thumb is to invest if the Profitability Index is greater than 1. In government organizations, PI is referred to as “benefit-cost” ratio. 
(6) NPV Profile is a sensitivity analysis report which shows a project’s relationship of NPV as a function of various discount rates. NPV is graphed on the y-axis and discount rates are graphed on the x-axis.

Weeding Out Special Cases
There are often ranking conflicts between NPV and IRR. In single conventional projects, NPV and IRR will agree on the investment criteria. However, for two mutually exclusive projects, the project should be based on the NPV, because it reflects the most realistic discount and opportunity rate. For instance, project scales could lead to a project having a larger IRR in the smaller scale project vs. the larger project scale, which may have a greater NPV. 

Multiple IRRs and No IRR problems do come up. In unconventional cash flows, it is possible to have multiple IRRs where NPV equals 0 more than once. If this does come up, you may construct a NPV Profile to determine the best NPV of the overall project. In cases where there are two IRRs, NPV would be at the highest value in between the two discount rates that make NPV equal 0. It is also important to note that when cash flows do not have an IRR, it is not necessarily a bad thing, as NPV can still be greater than zero. 

Popularity and Usage of the Capital Budgeting Method 
Determining the effect of capital budgeting and a stock is contingent on the information already known to investors. Ultimately, a stock price is a function that reflects “growth” expectations. Therefore, upon the announcement of a project, the stock price should have reflected any NPV expectations. If actual NPV were greater than expectations, then the implications of the stock price should appreciate (and vice versa if NPV was less than expected). The integrity of a corporation’s capital budgeting process is important because it can demonstrate two things about the quality of management, which includes the (i) degree to which management embraces the goal of shareholder wealth maximization and (ii) effectiveness in pursuing that goal. ​​