Capital budgeting
Capital budgeting evaluates long-term investments such as new equipment, factories, or products. Because money has time value, the best methods discount future cash flows.
What capital budgeting is
Capital budgeting is the process of evaluating and selecting long-term investments. These decisions involve large sums, last many years, and are hard to reverse, so they need careful analysis of expected cash flows, timing, and risk.
The payback period
The payback period is the time needed for an investment's cash inflows to recover its cost. With equal annual inflows, payback = investment / annual cash inflow. It is simple and highlights liquidity and risk, but ignores the time value of money and cash flows after the payback point.
The accounting rate of return
The accounting rate of return (ARR) = average annual net income from the investment / average (or initial) investment. It uses accounting profit, which is familiar to managers, but ignores the time value of money and focuses on profit rather than cash.
Net present value
Net present value (NPV) discounts all future cash flows at the required rate of return (cost of capital) and subtracts the initial investment: \(NPV = \sum \frac{CF_t}{(1+r)^t} - I_0\). A positive NPV means the investment earns more than the required return and should increase the firm's value.
Internal rate of return
The internal rate of return (IRR) is the discount rate at which NPV equals zero. If IRR exceeds the required rate of return, the project is acceptable. IRR is intuitive as a percentage, but can be misleading for projects with unusual cash flow patterns or when comparing mutually exclusive projects of very different sizes; NPV is generally preferred.
Estimating cash flows
Relevant cash flows include the initial investment, incremental operating cash inflows and outflows, changes in working capital, tax effects (such as tax savings from depreciation), and the residual value at the end. Sunk costs are excluded; opportunity costs are included.
Risk and sensitivity analysis
Future cash flows are uncertain. Sensitivity analysis tests how NPV changes if key assumptions, such as sales volume or costs, change. Scenario analysis considers best, worst, and expected cases. Riskier projects are evaluated using higher discount rates.
Worked example
A machine costs 50,000 dollars and saves 15,000 dollars a year for 5 years. Payback = 50,000 / 15,000, about 3.3 years. At a 10% required return, the present value of the savings is \(15{,}000 \times 3.791 \approx 56{,}865\) (using the 5-year annuity factor), so NPV is about 6,865 dollars, positive: the investment should be accepted.
Key takeaways
Capital budgeting evaluates large, long-term, hard-to-reverse investments. Payback measures how quickly cost is recovered but ignores time value. ARR uses accounting profit and ignores time value. NPV discounts cash flows at the required return; positive NPV adds value. IRR is the rate where NPV is zero; accept if above the required return, but prefer NPV for comparisons. Relevant cash flows include taxes and working capital. Sensitivity and scenario analysis address risk.
Flashcard
Evaluating long-term investments
Check your understanding
An investment costs 40,000 dollars and generates 10,000 dollars a year. What is its payback period?