essay questions on capital budgeting

60 Important Capital Budgeting Questions and Answers [With PDF]

The 6th chapter of our finance learning course is “ Capital Budgeting .” In this article, we’ll learn the 60 most important capital budgeting questions and their answers.

By reading this post, you may quickly prepare for “finance” courses and for any competitive tests such as school and college exams, vivas, job interviews, and so on.

Capital Budgeting Questions and Answers   

Question 01: What is capital budgeting?

Answer: Capital budgeting is the process of finding, analyzing, and choosing investment projects with returns that are expected to last longer than one year. 

Ideally, companies should pursue all projects and opportunities that increase shareholder value.

Question 02: What is another name for capital budgeting?

Question 04: What are the types of projects?

Question 05: What are the steps in the capital budgeting process?

Question 06: What are the fundamental principles of capital budgeting?

Question 08: What are the benefits or importance of capital budgeting?

Question 09: What are the features or characteristics of capital budgeting?

Question 10: What are the constraints or limitations of capital budgeting?

Answer: The top five constraints of capital budgeting are as follows:

Question 12: What are the factors affecting capital budgeting decisions?

Answer: The amount of money paid out or received at the start of a project or investment is referred to as the “initial cash outflow.”

Answer: The initial cash flow is calculated in the following manner:

Answer: Interim incremental net cash flows are the extra operating cash flows that a company gets because it started a new project.

Question 17: How do you calculate the interim incremental net cash flows?

Question 18: How do you calculate the terminal-year incremental net cash flow?

Answer: The terminal year incremental net cash flow is calculated as follows:

Answer: The following are the different types of capital budgeting decisions:

Answer: This is an important decision in capital budgeting. The farm would invest in the project if it were accepted, but not if it were rejected. 

Under the accept or reject decision, all separate products that meet the minimum investment criteria should be put into place.

Question 22: What is a capital rationing decision?

In reality, a business’s budget for project implementation is limited. There are many investment proposals competing for those limited funds. As a result, the business must ration them. 

Answer: Using different capital budgeting techniques, this method starts by figuring out how likely each project is to happen. 

The project with the highest return is then ranked first, followed by the project with the lowest return. The project with the highest ranking is chosen, and the investment decision is made.

Answer: The discounted methods of capital budgeting are as follows:

Answer: When you divide the average annual net income after taxes by the average investment, you get the average rate of return. It considers both the amount invested and the profit generated. 

It makes the right assumption that future cash flows from different time periods have different values and can’t be compared until their equivalent present values are known.

Question 29: What is an internal rate of return (IRR)?

Answer: The profitability index is the ratio you get when you divide the present value of all future cash inflows by the present value of all cash outflows.

Question 31: What are the techniques or methods of capital budgeting?

R = Required rate of return for the investment

Let’s calculate the net present value (NPV) using a straightforward example.

ABC Corporation is thinking about investing $30,000 in a project that will generate after-tax cash flows of $12,000 per year for the next three years and an additional $20,000 in the fourth year. The required rate of return is 13%.

       =10.61

Since the NPV is positive, the investment will therefore be accepted.

Answer: The net present value (NPV) method has the following benefits:

Question 35: What are the disadvantages of using the Net Present Value (NPV) method?

IRR = r = the discount rate that makes the net present value of the investment equal to zero.

Question 38: What are the benefits of using the Internal Rate of Return (IRR) method?

Question 39: What are the disadvantages of using the Internal Rate of Return (IRR) method?

Answer: The following are the disadvantages of the Internal Rate of Return (IRR) method:

Question 41: What are the PBP decision criteria?

Question 42: What are the benefits of using the Pay Back Period (PBP) method?

Answer: The Payback Period (PBP) method has the following disadvantages:

Question 44: What is the Discounted Pay Back Period (DPBP) formula?

a= the year of the cumulative inflow closest to the year of the initial cash outflow

c=Cumulative inflow of a year

Question 45: What are the benefits of the Discounted Pay Back Period (DPBP) method?

Answer: The following are the benefits of the discounted payback period (DPBP) method:

Answer: The following are the disadvantages of the Discounted Pay Back Period (DPBP) method:

Question 47: What is the formula of an average or accounting rate of return (ARR)?

ARR = Average net income/Average Investment

Answer: The following are the ARR decision criteria:

Question 49: What are the benefits of calculating the average rate of return (ARR)?

Question 50: What are the disadvantages of using the Average Rate of Return (ARR) method?

Answer: The following are the disadvantages of the Average Rate of Return (ARR) method:

Answer: The following is the formula for calculating PI:

PI= 1+(NPV/Initial Investment)

The example below will show you how to calculate the Profitability Index (PI).

Assume ABC Corporation is considering a $42,000 investment in a capital project that will generate after-tax cash flows of $14,000 per year for the next five years. The cost of capital is 10%.

Initial Investment = $42,000

Question 53: What are the advantages of the Profitability Index (PI) method?

Question 54: What are the disadvantages of using the Profitability Index (PI) method?

Answer: The three important differences between capital budgeting and capital rationing are as follows:

Question 56: What is the distinction between Net Present Value (NPV) and Internal Rate of Return (IRR)?

Answer: The following are the three important distinctions between net present value (NPV) and profitability index (PI):

Question 58: Which technique, NPV or IRR, is preferred and why?

Answer: NPV is the superior approach to capital budgeting for the following reasons:

Answer: Even though the NPV method is better in theory, financial managers prefer the IRR method for the following reasons:

Answer: In the following situations, it is thought that the profitability index is better than the net present value (NPV).

I hope that by the end of this post, you will have a good understanding of the “ capital budgeting ” chapter.

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Capital Budgeting: Important Problems and Solutions

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on January 30, 2024

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The cost of a project is $50,000 and it generates cash inflows of $20,000, $15,000, $25,000, and $10,000 over four years.

Required: Using the present value index method, appraise the profitability of the proposed investment, assuming a 10% rate of discount.

The first step is to calculate the present value and profitability index.

Total present value = $56,175

Less: initial outlay = $50,000

Net present value = $6,175

Profitability Index (gross) = Present value of cash inflows / Initial cash outflow

= 56,175 / 50,000

Given that the profitability index (PI) is greater than 1.0, we can accept the proposal.

Net Profitability = NPV / Initial cash outlay

= 6,175 / 50,000 = 0.1235

N.P.I. = 1.1235 - 1 = 0.1235

Given that the net profitability index (NPI) is positive, we can accept the proposal.

A company is considering whether to purchase a new machine. Machines A and B are available for $80,000 each. Earnings after taxation are as follows:

Required: Evaluate the two alternatives using the following: (a) payback method, (b) rate of return on investment method, and (c) net present value method. You should use a discount rate of 10%.

(a) Payback method

24,000 of 40,000 = 2 years and 7.2 months

Payback period:

Machine A: (24,000 + 32,000 + 1 3/5 of 40,000) = 2 3/5 years.

Machine B: (8,000 + 24,000 + 32,000 + 1/3 of 48,000) = 3 1/3 years.

According to the payback method, Machine A is preferred.

(b) Rate of return on investment method

According to the rate of return on investment (ROI) method, Machine B is preferred due to the higher ROI rate.

(c) Net present value method

The idea of this method is to calculate the present value of cash flows.

Net Present Value = Present Value - Investment

Net Present Value of Machine A: $1,04,616 - $80,000 = $24,616

Net Present Value of Machine B: $1,03,784 - 80,000 = $23,784

According to the net present value (NPV) method, Machine A is preferred because its NPV is greater than that of Machine B.

At the beginning of 2024, a business enterprise is trying to decide between two potential investments .

Required: Assuming a required rate of return of 10% p.a., evaluate the investment proposals under: (a) return on investment, (b) payback period, (c) discounted payback period, and (d) profitability index.

The forecast details are given below.

It is estimated that each of the alternative projects will require an additional working capital of $2,000, which will be received back in full after the end of each project.

Depreciation is provided using the straight line method . The present value of $1.00 to be received at the end of each year (at 10% p.a.) is shown below:

Calculation of profit after tax

(a) Return on investment

(b) Payback period

Payback period = 2.9 years

Payback period = 3.5 years

(c) Discounted payback period

(d) Profitability index method

Capital Budgeting: Important Problems and Solutions FAQs

What are some examples of capital budgeting.

Examples of capital budgeting include purchasing and installing a new machine tool in an engineering firm, and a proposed investment by the company in a new plant or equipment or increasing its inventories.

What is the process of capital budgeting?

It involves assessing the potential projects at hand and budgeting their projected cash flows. Once in place, the present value of these cash flows is ascertained and compared between each project. Typically, the project that offers the highest total net present value is selected, or prioritized, for investment.

What are the primary capital budgeting techniques?

The primary capital budgeting techniques are the payback period method and the net present value method.

What are the capital budgeting sums?

The capital budgeting sums are the amounts of money involved in capital budgeting.

What are the capital budgeting numericals?

The capital budgeting numericals are the various types of numbers used in applying different capital budgeting techniques.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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Module 6: Capital Budgeting

A factory manager believes some of their plant’s equipment is outdated so they schedule an appointment with a major supplier. The salesperson confirms the equipment should be replaced and proceeds to describe what their company has to offer.  Does the factory manager make the purchase immediately?  Of course not—in addition to getting a number of competing bids, the manager must carefully compute whether the expected future benefits from the new equipment exceed its initial and ongoing costs on a present value basis. If they do not, then the company is failing to earn its required rate or return (RRR) and the project should not proceed.

Capital budgeting is a critical activity at any business.  It helps senior management establish a long-term strategic direction for the company by evaluating different growth opportunities such as introducing new products, expanding into new markets or acquiring competing firms.  At the lower levels of the firm, it is invaluable in assessing product improvements ideas, cost-saving plans, or proposed capacity additions.  Maintaining a constant flow of new investments is essential to a company’s long-term profitability and survival.

Although accountants typically take the lead in calculating a project’s net present value (NPV), specialists from the other business areas play a critical role in estimating a project’s future benefits and costs; determining an RRR that accurately reflects a project’s risk level; and ensuring a company’s strategic goals are met.  This team approach results in a very thorough project evaluation that helps companies cope with the risk of high initial costs and uncertain future benefits.

6.1 Capital Budgeting Process

The capital budgeting process allocates a company’s investment funds to major projects.  The process becomes more elaborate as organizations become larger and the value and complexity of projects increase.  Many large companies have formal capital expenditure planning committees with detailed operating procedures that approve all major capital expenditures.  These committees generally consist of a team of experts from across the company and its different disciplines including accounting, finance, marketing, operations, and human resources.  They critically review all projects from their varying perspectives to ensure that they are financially and operationally sound and consistent with the company’s strategic plans.  As the size of capital expenditures decrease and become more routine, investment decision making is pushed down into a company’s divisions and departments and the processes used to assess projects become simpler.  Most organizations establish cost limits that determine which level of management has authority to approve a project.

The five steps in the capital budgeting process include:

• Step 1–Project idea generation.  Ideas can be found internally or by scanning the external business environment, benchmarking the company against its competitors, or acquiring innovative companies or product ideas.  Smaller investment proposals may originate at the department level among junior managers and line workers formed into autonomous work teams.  As projects grow in value, divisional and corporate management becomes more involved.  Pay and human resource systems at all levels should be designed to encourage employees to contribute.
• Step 2–Screening of proposals.  Before committing to an expensive evaluation of a project, the capital expenditure planning committee or senior management will review the project to ensure it has a reasonable chance of success and is consistent with the company’s strategic plans.
• Step 3–Project evaluation.  A project’s profitability is determined using different evaluation methods including payback period, discounted payback period, accounting rate of return (ARR), net present value (NPV), internal rate of return (IRR), or profitability indexes (PI).  In addition to a thorough quantitative analysis, business units must also prepare a written description and justification which describes how the project supports the organization’s strategic goals.  All forecasts should be consistent with a common economic outlook provided by the company.
• Step 4–Preparation of the capital budget. All unprofitable or strategically undesirable projects are eliminated and the remaining projects are ranked based on their profitability along with any resource constraints such as limited funding or a lack of manpower availability.  Some projects are mandatory and must be done in order to comply with health and safety or environmental regulations in which case the goal to complete the project efficiently.  Others may lose money but are accepted anyway for strategic reasons to give the company exposure to a new industry or to development new competencies in hopes of earning positive returns in the future.  Pet projects championed by influential managers that usually do not go through the normal approval process or are approved based on overly optimistic projections should be avoided.
• Ascertains why variation between planned and actual performance occurred so any lessons learned can be applied to current and future projects.
• Strengthens a manager’s estimating abilities by holding them accountable for their forecasts and project selections.
• Detects biases by managers who consistently over estimate benefits or underestimate costs.
• Discourages pet projects by influential managers.
• Provides an excellent training opportunity for new managers and can be part of their performance review.
• Provides an excellent source of new project ideas.
• Monitoring and post-completion audits should be conducted by individuals who are not involved in the project selection process to ensure their objectivity and help eliminate the psychological and internal political barriers to cancelling a project.  Once a manager or business unit receives approval for a project, they are very hesitant to admit that they might have made a mistake and relinquish resources.  Losses will continue longer than necessary especially if these managers are able to use their connections within the organization to gather support.

Project Evaluation Methods

There are six different methods companies commonly use to evaluate capital projects.  Most are based on cash flow estimates instead of accounting estimates which are heavily influenced by the accounting policies adopted.

Exhibit 1: Failure to Consider the Time Value of Money

Exhibit 2: Bias Against Long-term Projects

•   Discounted payback period.   This is the time it takes to recover a project’s initial investment from its discounted future cash flows.  The advantages and disadvantage of this method are similar to the payback period method except present value is used and the discount rate can be adjusted to reflect varying levels of risk.  If a project pays back its investment on a discounted basis it will make a profit, but it still may be rejected if the arbitrary cut-off point is not reached.
• Accounting rate of return (ARR).   It is a project’s average net income divided by the average assets used to earn that income over its life.  This is the only method that uses accounting estimates instead of cash flow estimates to determine a project’s rate of return.  Even though this approach does not use cash flows or present value, it is popular among manager’s because it shows how a proposed project will affect a company’s rate of return assets over the life of the project.
• Net present value (NPV).  This is the present value of a project’s future cash flows minus the initial investment or its profitability in dollar terms.  The discount rate used to determine the present value of future cash flows is the RRR that investors require to be fairly compensated for a project’s risk.  A project with a positive NPV is generating a higher return than the RRR or what economists call excess profits.  In competitive markets, there should be few excess profits due to the entry of new competitors.  The advantages of this method are the NPV is in dollars so it can be added directly to the company’s market value to determine the effect on share price.  Also, the RRR can be adjusted to reflect the varying risk levels of different projects or specific cash flows within project.  In order to maximize a company’s share price, all positive NPV projects should be accepted.  Excel provides a function to calculate a project’s NPV.
• Internal rate of return (IRR).  This a project’s rate of return that equates its initial investment with its future cash flows.  If the IRR was used as the RRR, a project’s NPV would be zero.  The difference between the IRR and RRR is the project’s excess profits expressed as a percentage.  Some company’s prefer IRR because it is easier to communicate than NPV which is in dollars.  IRR can also be used if a company cannot accurately estimate its RRR.  Its disadvantages are IRR cannot be adjusted for the risk of specific projects or cash flows like the RRR.  Also, IRR has a number of mathematical problems that may result in the wrong project being selected. Excel provides a function to calculate a project’s IRR.
• The NPV and IRR approaches are very similar.  To relate these two methods, analysts sometimes create an NPV profile that graphical shows a project’s NPV at different RRRs and its IRR.  Exhibit 3 shows a project with an initial investment of CAD 300 that generates yearly cash flows of CAD 200 over two years.
• Profitability index (PI). This is the ratio of the present value of a project’s future cash flows to the initial investment.  A project has a positive NPV if its profitability index is higher than one.

NPV is the preferred method for evaluating capital projects especially for large companies who better understand the limitations of the other approaches.  Payback and IRR are used to supplement NPV, but are typically not the primary methods partially because of the mathematical problems with the IRR.  The remainder of this module will focus on the NPV method after carefully considering these problems.

Mathematical Problems with IRR

The IRR method’s mathematical problems relate to the re-investment rate used for the cash flows generated by the project, the potential for multiple IRRs, and faulty decisions when choosing between mutually exclusive projects.

• Re-investment rate.   IRR is the rate of return that equates a project’s initial investment with its future cash flows.  This method assumes that when cash flows are received over a project’s life that they are re-invested at the IRR.  In practice, this assumption may not be accurate as funds will likely be re-invested in other capital budgeting projects or investments with varying rates of return.  If the rate of return on the project and the re-investment rate are expected to be materially different, then a modified IRR (MIRR) should be calculated.  Using this method, the future values (i.e. not present value) of all recurring cash flows are calculated at the end of the project’s life using the re-investment rate.  The interest rate that equates the total of these future values with the initial investment is the project’s modified IRR.  The re-investment rate is usually assumed to be the RRR as this is what a firm will earn on average on all its projects if markets are competitive.  Excel provides a function to calculate a project’s MIRR.

Exhibit 4: Understanding Multiple IRRs

• In this example, the project has a negative NPV at an RRR of 0.0%, but then the NPV rises as the RRR rises. This is because the present value of the positive cash inflow in Year 1 falls as the RRR rises, but the negative cash outflow in Year 2 rises at a faster percentage rate as it is further in the future. If the negative cash flow in Year 2 rises at a faster rate, then the difference between the Year 1 and Year 2 cash flows will become more positive causing the NPV to rise. If the RRR rises to 11.4%, the project will actually breakeven after which the NPV will become positive. The NPV will remain positive until the RRR reaches 45.5% when the NPV will become negative again. This is because the benefit from the different rates of change in the positive and negative cash flows decreases as the RRR rises and is eventually surpassed by the decline in present value due to the increase in the RRR.
• Again, the IRR is the RRR that results in an NPV of zero.  Since the NPV was zero at both an RRR of 11.4% and 45.5%, this means there are two IRRs.  The maximum number of IRRs is equal to the number of times the sign of the cash flows changes.  The actual number depends on the magnitude of the individual cash flows which will vary with each project.  There is usually only one IRR, but users should be aware of potentially confusing results.  Using the MIRR instead of the IRR, will eliminate the multiple IRR problem.

Exhibit 5: Deciding Between Two Mutually Exclusive Projects

Project 1 has a higher IRR than Project 2, but Project 2 has a higher NPV up to an RRR of 9%. After 9%, Project 1 has the higher NPV of the two projects. The NPV results change because even though Project 2 has higher total cash inflows, they are further in the future so are more greatly affected by an increase in the RRR. As the RRR rises, Project 2’s NPV will fall faster than Project 1’s NPV until Project 1 eventually has the highest NPV. Because of this problem, the NPV method should always be used to choose between mutually exclusive projects.

6.2 Applying NPV Analysis

Types of capital budgeting decisions.

There are two general types of capital budgeting decisions.

• Replacement.  NPV measures the difference in cash flows between two alternatives which are to continuing operating an existing asset or to replace it with another asset that is more efficient.
• Standalone.   NPV measures the difference in cash flows between two alternatives which are to do nothing or to expand/change a company’s operations in some way.

Data must be collected for both alternatives in a replacement decision.  No information is needed for the do nothing alternative in a standalone decision.  NPV in each case will measure how much better or worse off a company will be if they undertake the project.

Projects can also be classified as independent, mutually exclusive, or contingent.  Independent means they can be accepted along with any other project.  Mutually exclusive means two or more projects cannot be done together as they are likely options to accomplish the same task.  Contingent means one project has to be completed before another product can begin.

NPV Checklist

When using the NPV method, the following checklist helps ensure that all relevant cash outflows and inflows are considered:

• Cost of assets (cash outflow)
• CCA tax shield on assets (cash inflow)
• Increase or decrease in NWC (cash outflow or inflow)
• Incremental after-tax net cash flows (cash inflow)
• Disposal value of assets (cash inflow)
• Lost tax shield on disposal of assets (cash outflow)
• Return of NWC to previous levels (cash inflow or outflow)
• Decommissioning costs (cash outflow

Initial cash flows occur at the start of a project and include the cost of any fixed assets and the tax savings that are realized from claiming depreciation on these assets.  Most new projects also require additional net working capital (NWC) although sometimes NWC will fall if more efficient equipment is purchased that operates faster or is less prone to break down.  Recurring cash flows include the after-tax net cash flows expected on an ongoing basis over a project’s life.  These can come from selling new products, selling additional units of existing products, price increases or cost reductions.  Terminal cash flows occur at the end of a project.  They include the proceeds from any asset disposals and the lost tax savings from no longer being able to claim depreciation on these amounts.  NWC will also return to previous levels.  In some industries, companies have to incur considerable decommissioning costs closing down a factory or mine and potentially rehabilitating the site to prevent future environmental problems.

Estimating Cash Flows

When estimating and discounting cash flows using the NPV method, there are a number of important principles to remember.

• Include relevant incremental after-tax cash flows. Only incremental cash flows that specifically relate to a project are relevant in NPV analysis.  These cash flows measure the actual costs incurred and benefits received at specific points in time over a project’s life and are not affected by the accounting policies adopted.  Determining the effect of taxation on cash flows can be difficult but these amounts are usually significant so they cannot be ignored.  Be careful not to miss any relevant cash flows or double count them.
• Use opportunity cost. Projects sometimes use assets that a company already owns.  The cost of these assets is not their current net book value but their opportunity cost.  Opportunity cost is the price that outsiders are willing to pay for an asset, so it is what the company is giving up when the asset is used in a project.  It is determined by an asset’s best alternative use.  For example, if a patent was purchased for CAD 50,000, but an outsider is willing to pay CAD 100,000, then CAD 100,000 is what should be included as the initial cost in NPV analysis.  If CAD 10,000 is all the company can negotiate, then that amount should be included.
• Ignore sunk costs. Sunk costs are expenditures that cannot be recovered through a sale. Because they cannot be recovered, they are not relevant to a decision.  Management accountants say “a sunk cost is no cost.”  For example, if a company has already spent CAD 50,000 on a feasibility study for a new project, no cost should be included in NPV analysis unless it can be recovered by selling it to an outside group who is interested in taking over the project.  NPV should only include a project’s future costs and benefits and not any sunk costs.
• Incorporate side effects. Consider whether a proposed project will cannibalize or stimulate sales of existing company products.  If so, the lost or additional contribution margins should be included in NPV analysis.  Also consider how competitors will respond such as by lowering prices or entering the new market.  With competition, most excess profits are usually eliminated.
• Consider qualitative factors. A project may have negative side effects like lowering employee morale due to layoffs, environmental problems, or community or political opposition that are difficult to quantify. These factors should be considered and may cause a profitable project to be rejected.
• Be cautious of overhead allocation. Allocations of existing factory or corporate overhead should be ignored.  Only include increases in overhead caused by the project and be careful not to underestimate the additional expenditures required.
• Ignore financing costs. Financing costs such as interest paid to debt holders and dividends payments to equity investors should not be included as cash outflows since they are already reflected in the RRR used to determine a project’s NPV.  The only exception are issuance costs relating to any new debt or equity raised to finance the project as these costs are usually not be included in the RRR.
• Apply the correct discount rate . RRRs are typically nominal interest rates that include inflation, so future cash flow estimates must incorporate inflation as well otherwise the project’s NPV will be understated. RRR should reflect the riskiness of the proposed project and not the company’s overall cost of capital which is the average of all its existing business units.  RRR should also not be the cost of any financing specifically used to fund the project such as a new loan.

Capital Cost Allowance

Under the Income Tax Act (ITC), businesses must adopt capital cost allowance (CCA) as their depreciation method for tax purposes.  CCA is a declining-balance depreciation method which categorizes assets into one of 18 different classes.  The cost of individual assets in each class are pooled together to calculate CCA.  Each class has its own depreciation or CCA rate that is applied to the declining balance or undepreciated capital cost (UCC).  This rate generally reflects the expected life of the assets in that class (i.e. longer lasting assets have lower rates) but other considerations such as stimulating investment may result in higher rates (sometimes 100%) and a faster tax write-off.

Most asset classes are subject to the half-year rule which only allows half of the net acquisitions to be included in the class each fiscal year with the remainder added in the subsequent year.  Net acquisitions are the net of all asset purchases and sales.  The half-year rule was introduced because companies regularly bought assets at yearend but still claimed a full year’s CCA.  For convenience, instead of requiring companies to prorate CCA based on the date of purchase, the half-year rule assumes all assets are bought half way through the year.  A typical asset class might look like in Exhibit 6:

Exhibit 6: Mechanics or a CCA Pool

Although CCA is a non-cash expense and should not be deducted in calculating NPV, being able to deduct CCA for tax purposes does reduce taxes payable which is a cash item.  This benefit is referred to as the CCA tax shield and its present value over an asset’s life can be calculated using the formula:

[latex]\text{Present value of CCA tax shield}=\text{(Investment)}\text{(Marginal tax rate)}(\frac{{\text{CCA rate}}}{{\text{CCA rate + RRR}}})(\frac{{2+\text{RRR}}}{{2(1+\text{RRR})}})[/latex]

There are a few asset classes that do not use the declining balance method and the half-year rule to calculate CCA.  For example, Class 14 assets (franchises, concessions, patents, and licences) are amortized on a straight-line basis over the life of the property with a full-year’s CCA in the year of acquisition.  The present value of the CCA tax shield has to be calculated separately for these classes.

6.3 Incorporating Inflation

In developed economies, central banks typically have general inflation targets of 2.0% per year but in developing markets inflation can be much higher.  It is unreasonable to assume that inflation is negligible.

Inflation is incorporated into NPV analysis using either the nominal or real approaches.  With the nominal approach, recurring and terminal cash flows are expressed in future dollars which includes an allowance for inflation.  To be consistent, the RRR must be expressed in nominal terms as well meaning it has an inflation component.  With the real approach, future cash flows are expressed in today’s dollars so no adjustment is made for inflation.  Since inflation is not included in future cash flows, it must be taken out of the discount rate resulting in a real RRR.  Companies must be careful not to mix up the two methods by expressing all cash flows in today’s dollars while using a nominal RRR.

Rates of return are normally expressed nominally in the financial markets, so the inflation component must be removed from the RRR if the real approach is adopted.  If the nominal RRR was 8.0% and inflation was 2.0%, then the real RRR would be 6.0%.  This real RRR is only an approximation.  An exact rate can be calculated using a formula referred to as the Fischer Effect:

[latex]\text{Nominal rate}=(1+\text{Real rate})\times(1+\text{Inflation rate})-1[/latex]

[latex]0.08=(1.0+\text{Real rate})\times(1.0+0.02)-1.0[/latex]

[latex]\text{Real rate}=0.0588\text{ or }5.88%[/latex]

This formula recognizes that investors must be compensated for inflation on both the original investment (as represented by 1.0 in the formula) as well as the real rate earned during the year.  The difference between the Fischer Effect formula and just subtracting the real rate and inflation rate is small, so the Fischer Effect is often ignored.

When incorporating inflation, do not assume the same inflation rate applies to all cash inflows and outflows. Even though the general inflation rate of the economy might be 2.0%, the inflation rate for individual cash flows can vary.  For example, commodity price can change dramatically due to shifts in supply and demand and geopolitical forces. Accurate inflation or price forecasts relating to all key inputs and outputs are essential.

Inflation is also problematic for businesses because once any capital costs are added to a CCA pool, they are not subsequently indexed for inflation.  This reduces the value of the tax benefits companies receive from deducting CCA.  The federal government has considered indexing the value of CCA pools to counter this effect, but has decided against it due to the magnitude of lost tax revenues.

6.4 Capital Rationing

The general rule in capital budgeting is a company should accept all projects with a positive NPV, but this is not always possible.  At the divisional level, managers normally receive a limited budget to spend on capital items.  If this budget is insufficient to finance all profitable projects, then the division will have to decide how to best allocate or ration these limited funds to maximize NPV.  When capital rationing is done at the divisional level, it is referred to as soft rationing.

If divisions are underfunded, it would be logical for a company to simply raise more capital for them.  As a company’s assets grow, they are financed with a combination of debt and equity based on the company’s optimal capital structure so not to overleverage the firm.  Raising new capital, especially equity, is not always easy.  Stock markets can be undervalued for extended periods of time making it ill-advised to issue new equity.  Even if stock markets are fairly valued, companies have an aversion to issuing new equity due to high issuance costs and potential control problems.  Retained earnings may be insufficient to fund maximum growth given a desired level of dividends, so a company may have no choice but to reduce its growth and ration its limited capital to maximize NPV.  A company could also have difficulty raising new funds if it is experiencing financial distress or its loan conditions prevent any additional borrowing.  Sometimes, the limitation on the size of the capital is not due to a lack of financing, but a shortage of other non-financial resources such human resources including qualified executives, engineers or marketing specialists. When capital rationing is done at the corporate level, it is referred to as hard rationing.

Capital Rationing Using Solver

If a company has a large number of positive NPV projects to choose from, it would be very difficult to determine which combination maximizes NPV manually.  For this, the Solver feature in Excel is an excellent tool.  To demonstrate capital rationing using Solver, enter the spreadsheet in Exhibit 7 containing the initial investment and NPV for five different projects along with the formulas.  The total amount available to spend on all capital projects is CAD 2,500,000 and Projects A and B are mutually exclusive meaning they cannot both be done.  All other projects are independent of each other.

Exhibit 7: Capital Rationing Using Solver

Open Solver under the Data tab in Excel.  In the drop box, complete the following:

Maximize F7.   Done by setting F7 as the objective function and instructing Excel to maximize that value.  F7 is the total NPV of all projects selected.

By changing variable cells D2:D6.  Excel will select all possible combinations of D2:D6 subject to any constraints.

Constraints.

• D2:D6 = Binary. Excel will only select combinations where D2:D6 are either “1” or “0”.  A “1” means the project is selected, while “0” means it is not.
• A7 ≤ 1. Cell A7 equals the addition of D2 and D3 which can only be “0” or “1” if Project A and B are mutually exclusive.
• E7 ≤ CAD 2,500,000. Excel will not consider a combination of projects if E7 exceeds the total capital budget of CAD 2,500,000.  E7 is the total investment in all projects selected.

Solve.   Excel maximizes F7 subject to the constraints and selects Projects B and C with a maximum NPV of CAD 1,100,000.

Instead of using Solver, some companies rank projects based on either their PI or IRR and simply go down the list accepting projects until the capital budget is completely spent.  This approach should not be used as it can generate a group of projects that do not maximize NPV.  Exhibit 8 contains the same example using a PI ranking.

Exhibit 8: Capital Rationing by Ranking PIs

Based on the PI ranking, Projects A, C, D, and E should be chosen.  The entire capital budget of CAD 2,500,000 is spent and projects A and B, which are mutually exclusive, are not both selected.  As can be seen in Alternative 1 and 2 below, the selection of A, C, D, and E does not maximize NPV though.  Alterative 2 maximizes NPV because even though Project B has a slightly lower PI than Project A, the lower PI is earned on a larger investment (CAD 2,000,000 versus CAD 1,000,000) leading to a higher overall NPV.

Exhibit 9: Incorrect Ranking Using PIs

6.5 Comparing Projects of Varying Lives

Much of the equipment a company buys such as water pumps or metal lathes is needed on an ongoing basis and must be replaced a number of times in succession as assets wear out.  A difficulty in analyzing these types of capital projects is that the equipment options being considered likely have different economic lives making a comparison of their NPVs difficult.  Two similar methods for dealing with this problem are chaining and equal annual annuity (EAA).  To demonstrate these methods, consider the example in Exhibit 10 of two mutually exclusive equipment options with an RRR of 10.0% and varying lives of three and six years.

Exhibit 10: Chaining and EAA

The lowest common multiple for the lives of the two equipment options is six years.  To meet its needs during this six-year period, the company has to purchase Equipment A twice or Equipment B once.  For Equipment A, NPV for the first three-year period is added to NPV for the second three-year period.  NPV for the second three-year period is discounted for three year since its implementation is deferred.  For Equipment B, NPV is calculated for the six-year period.  The option with the highest total NPV is selected.

Equipment A

[latex]\text{First 3-year period: }11,640\frac{{1-(1+1.10)^{-3}}}{{.10}}-25,000=3,946.96[/latex]

[latex]\text{Second 3-year period: }\frac{{3,946.96}}{{(1+.10)^{3}}}=2,965.41[/latex]

[latex]\text{Total NPV: }3,946.96+2,965.41=6,912.37[/latex]

Equipment B

[latex]\text{Total NPV: }7,325\frac{{1-(1+.10)^{.6}}}{{.10}}-21,000=10,902.28[/latex]

Equipment Option B is preferred.

Calculate an annual annuity that is equivalent to the NPV of Equipment A and B.  The equipment option with the highest annual annuity is preferred as this annuity will be earned each year regardless how many times the project is undertaken.

[latex]\text{NPV: }11,640\frac{{1-(1+.10)^{-3}}}{{.10}}-25,000=3,946.96[/latex]

[latex]\text{EAA: }3,946.96=P\frac{{1-(1+.10)^{-3}}}{{.10}}P=\text{CAD}1,587.13[/latex]

[latex]\text{NPV: }7,325\frac{{1-(1+.10)^{-6}}}{{.10}}-21,000=10,902.28[/latex]

[latex]\text{EAA: }10,902.28=P\frac{{1-(1+.10)^{-6}}}{{.10}}P=\text{CAD}2,503.24[/latex]

The chaining and EAA methods can be used to choose between mutually exclusive projects that repeat themselves in the future.  The method should not be used to compare one-time projects with different lives.  Also, for the project that will be repeated most often, analysts may want to include in the analysis changes in asset replacement costs caused by inflation or changes in technology that make the newer asset more efficient or profitable.  In practice, the materially principle and the ability to make accurate estimates should be considered before going to this level of detail.

6.6 Changes in NWC

Previously, any additional NWC relating to a proposed capital project was classified as an initial cash outflow.  When the NWC was liquidated at the end of the project, it was classified as a terminal cash inflow.  This treatment is an over-simplification as NWC actually changes continuously as sales change over a project’s life and not just at the beginning and end of the project.  Sales typically rise quickly but then level out and eventually fall based on a product’s or business’s life cycle.  Changes in NWC each period can be estimated using the financial ratio:

This ratio is equivalent to:

[latex]\text{NWC Turnover}=\frac{{\text{Sales}}}{{\text{NWC}}}[/latex]

[latex]\text{NWC}=\frac{{\text{Sales}}}{{\text{NWC Turnover}}}[/latex]

Sales estimates for the proposed project are available.  The relationship between sales and NWC as measured by NWC turnover may be assumed to remain constant or can be adjusted to reflect the project’s varying NWC requirements.  Knowing sales and NWC turnover, a project’s NWC needs can be calculated each period and the change can be included as either a cash inflow or outflow.

6.7 Taxation Effects of Terminal Cash Flows

With large capital projects involving land, building, equipment and government assistance, determining the relevant cash flows including the tax effects can be complex.

• Land.   A negative cash flow is included when land is purchased at the beginning of a project and a positive cash flow is recognized when it is sold at the end.  Land is a non-depreciating asset so there are no CCA tax savings, but there is a tax effect relating to any capital gain or loss recognized on the sale of land that must be included in NPV.  Under the ITA, only 50.0% of capital gains are taxable and only 50.0% of capital losses can be applied to reduce other capital gains to zero that year.  If taxable capital gains are insufficient that tax year to absorb all taxable capital losses, the losses can be applied to taxable capital gains going back three years and forward indefinitely until they are fully realized.  By only taxing half of capital gains, the government is encouraging risk taking and recognizing that a significant portion of the capital gain is due to inflation.
• Building.  A negative cash flow is included when a building is purchased at the beginning of a project and a positive cash flow is recognized when it is sold at the end.  A building is a depreciating asset so the present value of the CCA tax savings are recognized.  When the building is sold, the sale price is deducted from the class’s UCC and either a recapture or terminal loss is realized.  If the building is sold above its original cost, the original cost is instead deducted from the CCA pool and a capital gain is recognized on the additional amount received.  Capital losses cannot occur on depreciable assets. The tax effect of any recaptures, terminal losses or capital gains are included in NPV.
• Equipment.  A negative cash flow is included when equipment is purchased at the beginning of a project and a positive cash flow is recognized when it is sold at the end.  Equipment is a depreciating asset so the present value of the CCA tax savings are recognized.  When equipment is sold, the sale price is deducted from the appropriate class’s UCC.  A terminal loss or recapture can occur.  If the equipment is sold above original cost, the original cost is instead deducted from the class’s UCC and a capital gain is calculated on the difference.  Capital losses cannot occur on depreciable assets.  Capital gains on equipment are rare because they generally depreciate in value unlike land and many buildings.
• Government assistance.  Both federal and provincial governments provide investment tax credits (ITC) to encourage economic growth.  ITC are for investments such as new building and equipment, research and development, resource exploration, or employee training.  They are expressed as a percentage of the eligible expenditures and are paid by reducing taxes payable.  When ITC are given for the purchase of buildings or equipment, the capital cost added to the CCA class is reduced by the amount of the assistance so the company does not benefit twice.  Government assistance is also given in the form of cash grants or wage, rent, interest, and property tax subsidies.  The related cash flows should be reduced by the amounts of these payments.

More on Terminal Losses and Recaptures

A terminal loss occurs when an asset class’s UCC is positive and there are no assets remaining in the class.  The positive UCC indicates that a company has not taken enough depreciation in the past and can now recognized a tax benefit equal to the class’s UCC times the company’s marginal tax rate.  Terminal losses can occur with buildings because each building is held in its own class which must be close out when that building is sold.  They are far less likely with equipment as the classes generally contain a number of different pieces of equipment meaning the class is rarely empty.

Recaptures occur whenever an asset class’s UCC is negative regardless of whether the class is empty or not.  The negative UCC indicates that a company has taken too much depreciation in the past and now must pay taxes equal to the class’s UCC times the company’s marginal tax rate.  Recaptures occur can with buildings because, even though they are depreciable assets, they frequently appreciate in value leading to a negative UCC when the asset is sold.  Recaptures are far less likely to occur with equipment because of the positive UCC in the class relating to other assets in the pool and equipment generally does not appreciate in value.  If the company is growing at a reasonable rate, this UCC should be sufficient to absorb any asset sales.  Even if it is not, good tax planners will arrange to buy needed assets that year so the UCC remains positive thus preventing any recaptures.

As discussed, the tax effect of any capital gains, terminal losses or recaptures relating to equipment must be included in NPV but they are rare.  What must be included is the present value of future CCA tax savings relating to the difference between the UCC of the piece of equipment being sold and the amount received from its sale.  If this difference is positive, the company will continue to benefit from future CCA tax savings, but if negative, they will lose future CCA tax savings.

6.8 Managing Risk

Capital budgeting is an uncertain process.  Companies may be able to estimate a project’s initial cash flows with a high degree of certainty, but recurring and terminal cash flows that are five, ten, or fifteen years away are obviously much more difficult to forecast.  Because of this uncertainty, projects that were initially thought to be profitable may actually lose money for the company.  This risk cannot be avoided, but it can be reduced.  Common methods for managing risk include:

• Establish a minimum payback period.   Although NPV should be the primary method used to evaluate projects, companies can adopt a low discounted payback period cut-off point to reduce the risk of losing money.  Only projects that meet this more conservative target are considered.
• Subjectively adjust the RRR.  Introducing a new product in an unfamiliar market is obviously riskier than replacing existing equipment.  If a company uses its weighted average cost of capital as the RRR, the average level of risk for all its current projects is captured.  The RRR can be subjectively adjusted upwards or downwards by management to reflect the risk of a specific project as in Exhibit 11.

Exhibit 11:  Adjusting RRR for Project Risk

• Use sensitivity or scenario analysis.  Understanding the effect that changes in key variables like price or sales growth have on NPV, IRR or discounted payback period can help companies better manage project risk. Sensitivity analysis can be conducted using the Data Tables feature in Excel to see the effect of changing one variable at a time on NPV.  Excel’s Scenario Manager provides companies the option to define and save a number of scenarios consisting of a number of variables and also provides a scenario summary report.  The best-case, worst-case, most-likely case scenarios are commonly used in business forecasting.
• Use simulation.  This technique is an advanced form of scenario analysis where a large number of variables are selected.  A probability distribution is determined for each variable including its mean and standard deviation.  By conducting a large number of “runs” where all variables change concurrently based on their probability distributions, a more reliable estimate of the project’s NPV distribution can be made.  The mathematical complexity of this methods limits it use, but it is becoming more common in practice.  A simulation add-in in Excel called @Risk is available.      
•                                             
• Incorporate management options using decision trees.  Selecting a project is not a one-time decision requiring a company to make the entire investment upfront.  Large projects are usually divided into multiple stages with specific spending commitments at each stage.  Management only proceeds from one stage to the next if further investment is warranted based on new information such as proof of technical or market feasibility or customer demand.  Managers also make other decisions subsequent to the commencement of the project based on additional information that increases the project’s NPV and reduces the risk of losing money.  These decisions are called management or real options and typically include:
• Abandonment .  Scale back or abandon a project before the end of its life if sufficient demand does not materialize or costs are higher than expected.
• Timing .  Slow or accelerate the implementation of a project in reaction to new information.
• Growth .  Expand a project by increasing existing capacity, entering additional markets, or adding complementary products if demand if higher than expected.
• Flexibility .  Vary prices, inputs, outputs, and production methods over a project’s life in order to maximize profits.

6.9 Complex Capital Budgeting with Spreadsheets

Advantages of using spreadsheets.

Spreadsheets are invaluable in capital budgeting as they help to organize and automate a very complex process.  By using an input page that defines all of a project’s variables in one place, estimates can be easily changed and sensitivity and scenario analysis employed to test various alternatives.

Need for More Frequent Cash Flow Estimates

For simplicity, when first learning about capital budgeting, students assume that cash inflows and outflows all occur at year end.  As shown in Exhibit 12, this yearend assumption can lead to erroneous results when using NPV.

Exhibit 12:  Erroneous Resulting Using the Yearend Cash Flow Assumption

Projects A and B are very similar except for their annual cash inflows and outflows.  For both projects, the net cash flows are CAD 3,000 per year over each project’s 10-year life, but the individual cash inflows and outflows are much larger in Project B.  If the year-end assumption is used, Project A and B will have the same NPV.  But what if the company receives its revenue at year-end and incurs its costs uniformly thorough the year?  For Project A, the NPV falls slightly because the costs are being paid sooner, so they are higher on a present value basis thus lowering the NPV.  For Project B, the NPV falls by much more and actually becomes negative.  This is explained by the size of the individual cash outflows.  Because the cash outflows are so large, paying them monthly instead of annually will lead to a much bigger increase in costs thus lowering the NPV.

This example demonstrates that adopting the year-end assumption without reference to the actual timing of cash flows can greatly distort the NPV.  It this case, the company would have accepted a project that should have been refused.  The year-end assumption will lead to erroneous results when: 1) cash inflows and outflows are large in relation to their net values, and 2) cash inflows and outflows have different frequencies (i.e. monthly or yearly).  Both these are true in the case of Project B and are very common in practice.  To avoid this problem, cash flows should be measured on a monthly or quarterly basis so they are more accurately timed.

Capital Budgeting Using Spreadsheet

When using spreadsheets to analyze capital budgeting projects as om Exhibit 13, relevant cash flows are still classified as initial, recurring, and terminal, but with some changes.  Instead of classifying the present value of the tax savings relating to CCA on the building and equipment as initial cash flows, they are classified as recurring cash flows each month resulting in lower income tax and higher net operating cash flows.  The changes to NWC occur over the life of the project and are classified as initial, recurring and terminal cash flows.  The tax effects of any capital gains, terminal losses and recaptures on the disposal of land, building and equipment are included in terminal cash flows.

Once the net cash flows are determined for each period, the initial and monthly NPV are calculated by applying the RRR and these amounts are summed to yield the total NPV for the project.  The IRR is calculated using Excel’s IRR function with the net cash flows as the data range.  This is the monthly IRR since the net cash flows are monthly, so the result must be multiplied by 12 months to yield the annual IRR.  Cumulative initial and monthly NPV is an aggregate total of all initial and monthly NPVs.  The discounted payback period occurs when this amount becomes positive and remains positive.

Exhibit 13:  Format of a Capital Budgeting Spreadsheet

6.10 Capital Budgeting at Canadian Companies

Capital budgeting in practice.

The capital budgeting techniques described in this module are all used in industry to varying degrees.  Which practices are preferred by companies is an area of considerable research.  Academics are trying to determine how closely practice follows current corporate finance theory which is what was studied in this module.  More closely adhering to current theory increases corporate profitability and overall economic efficiency and, therefore, is of significant interest.  A recent study 1 of Canadian businesses found:

• Use of discounted cash flows.   Project evaluation methods that use discounted cash flows are “often or always” used by 84% of companies, with 58% using them as their primary method, and 26% using them as their secondary method.  Usage is higher among large firms due to their greater sophistication and resources.
• Preferred project evaluation methods.   The NPV, IRR, and payback period are the most popular methods.  As Exhibit 14 shows, NPV is the preferred method followed closely by IRR and payback period although large firms favour the IRR approach.  As discussed, companies typically used more than one method when evaluating a capital project.  NPV provides the most reliable measure of profitability, but IRR conveniently expresses the return in percentage form, and payback period provides a valuable measure of project risk.

Exhibit 14: Preferred Project Evaluation Methods in Canada

• Adoption of management options.   Researchers generally feel that management options is the most efficient way to allocate capital between projects because of its ability to incorporate flexible decision making into NPV analysis.  Regardless, management options is only “often or always” used by 10.4% of firms.  It is used primarily by large companies that make major capital investments, are subject to considerable project uncertainty, and have greater flexibility in their investment decision making.  This includes mainly natural resource, pharmaceutical and biotechnology enterprises.  Companies who do not use management options said it was because of a lack of expertise, its complexity and an inapplicability to their business.
• Incorporating risk.  Companies do adjust for project risk when evaluating capital projects but most do so subjectively base on their personal judgement.  Sensitivity analysis is also used extensively but more complex methods such as scenario analysis, decision trees, or simulation are not.  Large firms are more likely than small firms to incorporate risk into project analysis.

Exhibit 15:  Use of Risk-adjustment Methods in Canada

• Judgement is also employed to estimate a project’s future cash flows with 94.0% of firms “moderately or highly” dependent on this approach.  Quantitative forecasting methods are “moderately or highly” used by 70.1% of companies, and expert consensus opinion is “moderately or highly” used by 42.7% of companies.  Usage of these methods does not vary by firm size.
• Capital rationing.   Capital rationing is employed to allocate capital to competing projects when adequate funds are not available.  Small firms utilize capital rationing approximately 43% of the time, while large firms utilize it only 34%.
• Differences between countries.  U.S. companies are more likely to adopt capital budgeting methods that are consistent with corporate finance theory because that country has a more rigorous corporate governance system and larger firms.

Agency Costs in Capital Budgeting

Another important area of research relates to how agency costs affect the capital budgeting process.  According to corporate finance theory, firms should work in the best interest of their shareholders and attempt to maximize the value of the firm by selecting projects with the highest NPV.  In practice, managers pursuing their own self-interests prevent companies from achieving this goal.  Some typical management behaviours include:

• Empire building.   Managers prefer running larger firms especially if their pay is more closely linked to the size of the company and not its financial success.  This causes firms to overinvest in capital projects especially if they have considerable financial flexibility in the form of high cash balances or low financial leverage.
• Quiet life. Managers avoid difficult decisions.  This results in underinvestment if profitable projects are not pursued, or overinvestment if underperforming products, plants, or divisions are not discontinued.
• Short-term behaviour.  Managers select projects that increase short-term instead of long-term share performance.  They also underinvest in less noticeable assets like maintenance, employee training, or R&D to improve current results. This short-term focus maximizes a manager’s pay which is closely linked to near-term share performance under most executive compensation plans.  It also enhances a manager’s reputation and their current value in the labour market.
• Herding.  Managers follow industry investment trends with little regard for the profit potential of the different projects.  They feel comfort in following others, and can more easily rationalize their actions and defend their failures.
• Competence.   Managers play it safe and avoid investments, especially risker and more costly projects, to hide their lack of competence and avoid being evaluated.
• Overconfidence.  Managers are overly optimistic about the assets they control.  This causes them to overinvest by exaggerating the profitability of new projects, not cancelling poorly performing products or business units, and overpaying for acquisitions.
• Willingness to issue equity.   Managers think their company’s shares are undervalued and are reluctant to issue new equity.  This results in underinvestment as companies are forced to ration their capital and turn down positive NPV projects.

Senior management and capital expenditure planning committees must be cognizant of these problems and take steps to mitigate their impact.  A company’s strategic plans and performance evaluation and compensation systems must be adjusted so they do not encourage these behaviours.

1 Baker, H., Dutta, S., Saadi, S. (2011). Corporate Finance Practices in Canada:  Where Do We Stand? Multinational Finance Journal , vol. 15, no. 3/4, 157-192.

6.11 | Exercises

A. problem:  project evaluation methods at topley.

Topley Ltd. is analyzing the purchase of new equipment at a cost of CAD 220,000. It is estimated that it will reduce company cash outflows from operations by CAD 50,000 per year. Its estimated life is ten years, and it will have zero terminal disposal value. The RRR is 16.0%.

• Compute the payback period.
• Compute the discounted payback period.
• Compute the NPV.
• Compute the IRR.
• Computer MIRR.
• Compute the PI.

B. Problem:  Project Evaluation Methods at Cott Beverages

Cott Beverages is considering the purchase of a bottling machine for CAD 28,000.  It is expected to have a useful life of seven years with a zero terminal disposal price.  The plant manager estimates the following cash savings:

Cott has an RRR of 16.0%.

• Compute PI.

C. Problem: Standalone Decision at Rogers

Rogers Company has the opportunity to invest in a new business which requires the purchase of a machine for CAD 120,000.  The machine is expected to last for four years and have a salvage value of CAD 10,000.  Rogers’ staff has prepared the following budgeted income statement for each of the four years, based on expected sales of 450 units per year.

Other Information

• The above financial data is based on one shift. The company is confident they can generate sales of 450 units per year.
• A second shift would have to be introduced to produce more than 450 units. The operator for this second shift would have to be paid full salary even if the machine did not operate at capacity and the operator could not be asked to do other work due to strict work rules in the collective agreement.
• The machine would require an additional CAD 5,000 in raw materials and work-in-process inventory to be maintained at all times during the machine’s life.
• The equipment belongs to a CCA class with a 25% rate. The company has many other assets belonging to this class.
• The company’s tax rate is 45% and it has an RRR of 12.0%.
• The inflation rate is negligible.
• Should Rogers purchase the new machine?
• Would the recommendation change if the company estimated it could sell 650 units per year?

D. Problem:  Replacement Decision at Ruby

On January 1, 2003, Ruby Company was contemplating whether to replace a lathe that it uses to produce Widgets. The current contribution margin (profit after variable costs) is CAD 4.00 per unit.

A new lathe could be purchased for CAD 500,000 and it would last eight years at which time it would be worth CAD 80,000. The old lathe could be sold for CAD 50,000 currently, but could continue to be used for another eight years after which it would have a salvage value of CAD 10,000.

The company currently produces and sells 200,000 Widgets a year, which is expected to increase by 20,000 units with the purchase of the new lathe. Variable production costs are expected to fall by CAD 2.00 per unit. Inventory requirements are expected to increase by CAD 10,000 initially.

The lathe is subject to a CCA rate of 20%. Ruby’s RRR is 10.0% and its tax rate is 35%. The inflation rate is negligible.

• Should Ruby buy this new lathe?

E. Problem:  Replacement Decision at Zebra

Zebra Technology Ltd. is a manufacturing firm specializing in the production of sophisticated product components. The company is considering the purchase of a new piece of equipment.

The equipment would cost CAD 141,000 and have a salvage value of CAD 18,000 at the end of its six-year life. The new equipment would replace existing devices that are fully depreciated, but have a current market value of CAD 10,000. If the old equipment is kept for another six years, it would have a salvage value of zero.

Zebra Technology is currently selling 50,000 units a year. The new equipment should allow it to sell 15,000 additional units per year over the next six years.

Each unit sells for CAD 12.00 and this is not expected to change over the next six years. Variable costs of production are CAD 7.50 per unit, but this should fall to CAD 5.75 per unit with the more efficient machine. Fixed costs are expected to fall by CAD 10,000 per year.  The new equipment will also reduce the required investment in NWC by CAD 30,000.

Zebra Technology has an RRR of 11.5% after tax. These two pieces of equipment are both in a CCA pool with a rate of 20%. The marginal tax rate is 31%. The inflation rate is negligible.

• Should Zebra Technology buy this new equipment?

F. Problem:  Standalone Decision with Inflation at Weatherly

Weatherly Ltd. operates a large mine.  The company wants to purchase equipment to mine additional ore from an undeveloped area of the site.  Bernice Janzen, Weatherly’s controller, is analyzing whether to undertake this project.

The cost of purchasing and installing the equipment is CAD 3.5 million.  The useful life of the equipment is five years with a salvage value of CAD 450,000.

Weatherly estimates that an additional 6,000 pounds of the metal (16 ounces per pound) will be mined annually for the next five years using the equipment.  Janzen has estimated the price of this metal will average CAD 17.21 per ounce over this period.  The metal prices are uncertain and are a significant risk in this project.

Two new employees are required to operate the new equipment.  Salary and benefit costs for each of these employees are estimated to be CAD 115,000 annually over the next five years.  Equipment maintenance is expected to be CAD 65,000 per year.

The variable costs to mine and process the ore is CAD 5.24 per ounce.  Allocated existing fixed overhead is CAD 1.95 per ounce.

Janzen uses an RRR of 9.0% and a 21% tax rate to analyze this project.  The equipment has a 30% CCA rate.  Inflation is estimated to be 2.0% over the next five years.

• Determine the NPV of this investment using the nominal approach.
• Determine the NPV using the real approach.
• Is the inflation assumption realistic? Explain.

G. Problem:  Standalone Decision with Inflation at Quaker

Quaker Ltd. produces breakfast cereal, but is considering expanding into the packaged salad business. This expansion will require an initial investment in new equipment of CAD 2,500,000. The new equipment will be placed in a class with a CCA rate of 20%. At the end of the project, the equipment is estimated to have a salvage value of CAD 350,000.

Sales from the new venture are forecasted at CAD 2,900,000 per year for the first six years and CAD 3,500,000 per year for years 7 through 12.

Variable operating costs for the new venture are estimated at CAD 1,900,000 for the first six years, and CAD 2,100,000 for years 7 through 12. Fixed costs will be CAD 800,000 per year for the entire 12-year period which includes rent for the new production facility. NWC will average 30.0% of sales throughout the life of the project.

At the end of year 6, an CAD 850,000 overhaul of the new equipment will be undertaken. Under the Income Tax Act, this expenditure is capitalized in the same pool as the original equipment.  The half-year rule applies to this expenditure.

It is assumed that at the end of year 12, the equipment will be sold for its estimated salvage value and the overhaul will not affect this estimate. The firm’s marginal tax rate is 30%. The acquisition of the new equipment and any subsequent betterment are subject to an ITC of 5%.

Its RRR is 5.0%, which is used in all NPV analysis. Company policy is to add an additional 3.0% to this discount rate to allow for the extra risk resulting from a new project.

All estimates are expressed in today’s dollars and inflation is estimated to be 2.5% per year for the duration of the project.

• Should the proposed project be undertaken? Use the real NPV approach.

H. Problem:  Capital Rationing at Bosie

Bosie Ltd. is considering the following capital projects:

Bosie’s capital budget is CAD 12 million and Charlie and Delta are mutually exclusive.

• What projects should be undertaken to make optimal use of the company’s limited capital budget?  Use Solver in Excel.

I. Problem:  Projects of Varying Lives at Wilson

Wilson Company is trying to decide between two mutually exclusive projects. The relevant cash flows are:

Wilson’s RRR is 7.0%.

• Which project would be selected using the chaining method?
• Which project would be selected using the equal annuity method?
• What assumption is made when using both these methods? Is it always accurate?

J. Problem:  Projects of Varying Lives at Jensen

Jensen Industries is considering two mutually exclusive investments.  The relevant cash flows are:

The RRR is 8.0%.

• Which project should be selected using the chaining method?
• Which project should be selected using the equal annuity method?
• What assumption is made when using either of these two methods? Is it always accurate?

K. Problem:  Changes in Net Working Capital at Amsterdam

Amsterdam Ltd. has the option to buy a new machine that will increase sales each year over the project’s 3-year life beginning in 2013.

Prior to the undertaking the project in 2013, Amsterdam’s NWC turnover ratio in days was 40.0. This is estimated to increase to 46 days in 2013 due to increased inventory requirements relating to the new machine and then remain the same over the life of the project.

• Calculate the changes in net working capital in 2013, 2014, and 2015 that need to be incorporated into the NPV analysis.

L. Problem:  Taxation Effects of Terminal Cash Flows

For each case below, determine the relevant incremental terminal cash flows.

• A piece of land is purchased for CAD 1,000,000 at the beginning of a project and is sold 10 years later at the end of the project for CAD 4,000,000.  The tax rate is 35% and the capital gain inclusion rate is 50%.  Inflation is negligible.
• What if the land is sold for CAD 500,000?
• A building is purchased for CAD 500,000 at the beginning of a project and is sold four years later at the end of the project for CAD 600,000.  The asset is in a pool with a CCA rate of 10%.  The half-year rule applies. The tax rate is 35% and the capital gain inclusion rate is 50%.  Inflation is negligible.

• What if the building is sold for CAD 100,000?
• A piece of equipment is purchased for CAD 500,000 at the beginning of a project and is sold five years later at the end of the project for CAD 50,000.  The asset is in a pool with a CCA rate of 30%. The half-year rule applies. The equipment is one of many assets in the pool.  The RRR is 10.0%.  The tax rate is 35% and the capital gain inclusion rate is 50%.  Inflation is negligible.

• What if the equipment is sold for CAD 120,000?
• What if the equipment is sold for CAD 600,000?

M. Problem:  Managing Risk by Adjusting the Discount Rate at Rexall

On June 1, 2006, Rexall Ltd. was investigating whether to replace one of its existing injection molding machines with a new model being sold by one of its equipment vendors.

The new equipment will cost CAD 85,600 plus sales taxes of CAD 5,992, transportation of CAD 1,000, and installation of CAD 2,500. It is expected to last 10 years at which time it will have an estimated salvage value of CAD 12,000. The current injection molding machine has a market value of CAD 45,500 and will also last another 10 years at which time it will have a salvage value of approximately CAD 1,500.

The current machine produces 580,000 units per year, which sell at CAD 1.50. The new model is expected to increase output by 55,000 units and decrease current variable production costs of CAD 1.29 by CAD 0.35.  Fixed costs will rise by an estimated CAD 10,000 per year due to more complicated maintenance. The new machine is considered more reliable than the current model, so the company feels it will be able to reduce its inventory requirements by CAD 25,000.  All additional output can be sold.

Engineers estimate that the machine will have to be overhauled after five years and that this will cost CAD 200,000. Output is expected to be no more than 580,000 units for the five years after the overhaul.

The injection-molding machine is subject to a CCA rate of 25%. Rexall’s nominal RRR is 11.0%, and profits are subject to a marginal tax rate of 32%. Inflation is estimated to remain at 2.5% over the life of the machine.

The policy at Rexall is to adjust the company’s required rate of return to reflect the specific risk of each project. The following adjustment table is used:

• Should the proposed project be undertaken? Use the real NPV method.

N. Problem:  Managing Risk by Adjusting the Discount Rate at Dodson

Dodson Industries is trying to select the best of three mutually exclusive projects with varying levels of risk.  Project A is in risk class 5, Project B is in risk class 2, and Project C is in risk class 3.

Inflation is negligible.

• Which project should be undertaken?

O. Problem:  Managing Risk through Management Options at Hansen

Hansen Industries is contemplating developing a new product for sale in the domestic market.  It has decided to utilized decision tree analysis with management options and has broken down the project into the following phases:

Phase 1   

At the start of Year 1, Hansen will complete a technical feasibility study at a cost of CAD 620,000.  They estimate there is a 70% chance that the results will favour further development.

Phase 2  

At the start of Year 2, if Hansen decides to proceed, they will invest CAD 1,000,000 to build a protype of the product.  Hansen estimates there is 60% chance that the protype will be suitable for sale.

Phase 3   

At the end of Year 2, if Hansen decides to proceed, they will build a manufacturing facility for CAD 9,000,000

Phase 4  

During Year 3, Hansen will begin selling their product.  There is a 50% chance that demand will be strong generating net cash flows of CAD 17,500,000 a year for three years.  There is a 30% chance that demand will be average generating net cash flows of CAD 7,500,000 a year for three years.  There is also a 20% chance that demand will be low generating negative net cash flows of CAD 3,000,000 a year for three years.  If demand is low in Year 3, the firm will terminate the project and avoid the negative cash flows in Years 4 and 5.  If demand is high, the capacity of the plant will be expanded and the price of the product raised increasing cash flows to CAD 22,500,000 in Years 4 and 5.

Hansen’s RRR is 9.5%.  Inflation is negligible and all cash flows are after tax.

• Calculate the expected NPV and coefficient of variation for this project.
• What are the different types of management options being used?

P. Problem:  Managing Risk through Management Options at Acme

Acme Auto Parts is contemplating developing a new transmission.  Development costs are high and the chances of failure at the different stages of the project are significant.  In order to accurately estimate the NPV and reduce risk, Acme has decided to incorporate management options using decision trees.

Initially, Acme plans to spend CAD 500,000 for basic designs.  It believes that there is a 60% chance these plans will be successful.  If the basic designs fail, the company thinks it can get back part of the expense by selling its ideas to a foreign manufacturer for CAD 125,000.

The next stage, at the end of Year 1, involves developing five prototypes at a cost of CAD 95,000 each.  Once developed, the prototypes will be thoroughly tested and the company expects there is a 50% chance that these tests will be successful.  If unsuccessful, the prototypes and specially purchased production can be sold for CAD 150,000.

At the end of Year 2, a new production line will be built at a cost of CAD 5,000,000.  If demand is strong, net cash flows will be CAD 3,500,000 a year for 4 years.  There is a 60% chance this will occur.  If demand is moderate, net cash flows will be CAD 2,000,000 a year for 2 years and there is a 20% chance of this happening.  Finally, if the product is a failure, net cash flows will only be CAD 1,000,000 a year for one year.

If the production equipment is only used for one or two years, it could be sold for CAD 3,000,000.  If demand is high, management can expand the production line at a cost of CAD 1,000,000 in Year 3 in order to increase net cash flows to CAD 4,500,000 in Years 4, 5, and 6.

Acme’s RRR is 12.0%.  Inflation is negligible and all cash flows are after tax.

• Calculate the expected NPV and coefficient of variation of this capital project.

Q. Problem:  Complex Capital Budgeting with Spreadsheets at Magnum

Magnum Ltd. produces auto parts and assemblies for car and truck manufacturers around the world. Its headquarters are in Toronto, Ontario, but it currently has production facilities in Canada, the U.S., Europe, and China. Magnum began operations in 1975 in Oshawa, Ontario and has grown to be one of the world’s largest auto parts producers. Its keys to success have been its ability to remain non-unionized in the highly organized North American auto sector and relying heavily on flexible, automated production systems. It has been able to keep the union out of most of its plants by recruiting primarily immigrant workers who traditionally do not support unions.

Magnum has been growing at double-digit rates over most of the last 25 years, but has seen its growth fall dramatically in the last few years as the company has matured and competition has intensified. The falling growth rates have hurt the company’s share price creating considerable concern among shareholders and a lot of pessimism on the part of equity analysts. The CEO and founder, Heinz Becker, hopes to return growth rates to their previous levels by diversifying operations into new areas of manufacturing.

The two options for expansion that Magnum is currently contemplating are the design and assembly of an electric car and the production of solar generators for the industrial market.

Ford Motors, Magnum’s biggest North American customer, has asked the company to design and manufacture an electric commuter car modelled after the new General Motors Volt, which it would sell in its dealerships. It was felt that this car would appeal to young and environmentally conscious drivers who would be attracted by the vehicle’s low operating costs and emissions. Ford did not feel it could manufacture the product economically due its high labour costs, but still felt that it needed to include such a vehicle in its product line to attract younger buyers who might trade up to larger, higher-margin Ford cars, SUVs, or trucks as their incomes grow. Magnum is experienced in the manufacturing of auto parts and assemblies, and does not feel that the production of a complete vehicle would be beyond the company’s abilities.

The production of solar generators might prove more problematic for Magnum. In the past, it has produced engine parts, but never a full engine unit. The major concern though is that Magnum would have to establish a distribution system for this product. This would mean either establishing its own sales network or selling it though an existing system. A considerable number of John Deere, Caterpillar, and Komatsu dealers have expressed interest in selling this product and providing service.

Electric Cars

In order to build the electric cars, an assembly plant will have to be constructed. Magnum currently has enough capacity to manufacture most of the components for the new car and can buy the remainder from other suppliers.  The building is estimated to cost CAD 8,050,000 and the production equipment CAD 35,600,000. The plant will be located in a rural area so the land will be inexpensive at CAD 1,350,000. It is estimated the plant and equipment will have a life of 15 years before the product becomes obsolete and the facility is sold off. At that time, the land is expected to be worth CAD 2,900,000, the building CAD 1,360,000 and the equipment a negligible amount in today’s dollars. The building is subject to CCA at a rate of 10% and the equipment at rate of 30%. The building must be amortized separately in its own pool as per the Income Tax Act. Magnum is a large company, so the equipment pool includes numerous purchases and sales each year.

The capacity of the proposed plant is 48,000 vehicles per year. Sales are only expected to be 14,000 initially due to production “ramp up” problems and weak initial demand as Ford builds customer interest. Demand is expected to grow at 25.0% for the first 5 years followed by growth of 4.0% for the remaining 10 years. Demand for the electric cars is seasonal and is expected to adhere to the following demand pattern:

Magnum’s net working capital will increase with the addition of this new facility.  An NWC Turnover Ratio of 8.0 based on monthly sales is likely to be required over the life of the project.

Electric cars will be sold directly to Ford for CAD 10,760 who will distribute them through their dealer network. Magnum expects it will cost approximately CAD 10,250 to produce a vehicle. An additional CAD 1,580,000 in non-traceable factory costs are expected along with CAD 510,000 in incremental corporate overhead related to the project per year.

Prices and costs are expected to rise at the inflation rate of 2.0% per year for the duration of the project. Other than sales and costs of goods sold, all costs are incurred uniformly throughout the year.

Solar Generators

A new assembly plant will have to be built to manufacture the solar generators. Existing capacity could be used to produce most of the components; otherwise, parts production will be outsourced. Land for the new facility is estimated to cost CAD 2,320,000 and the building CAD 6,640,000. Production equipment worth CAD 24,550,000 will also be required with a maximum capacity of 23,500 units per year. The plant will have a life of 10 years at which time the land can be disposed for CAD 3,700,000 and the building for CAD 590,000. The estimated salvage value of the equipment is negligible. All estimates are in today’s dollars. The building is subject to a CCA rate of 10% and the equipment a rate of 30%. The building is being amortized in a separate pool as required in the Income Tax Act.

Magnum will have to increase its net working capital to support this project. The NWC ratio is expected to be 6.5 based on monthly sales.

Magnum is confident it can sell 5,300 generators in the first year. This will grow by 20.0% annually in the first five years followed by a normal growth rate of 3.0% for the remainder of the project. The selling price will be CAD 25,400 per unit. Sales are expected to adhere to the following seasonal pattern:

The cost of goods sold is estimated at CAD 24,250 per unit. Non-traceable factory costs are expected to be CAD 885,000 and incremental corporate overhead should approximate CAD 856,000 annually. Magnum has decided to sell the product through its own sales network as it feels neither John Deere, Caterpillar, or Komatsu dealers will put the needed effort into marketing the product. A national sales manager with a base salary of CAD 84,000 and a commission of 20.0% of gross profit would be hired along with five salespeople at a base salary of CAD 40,000 and a commission also of 20.0% of gross profit.

Prices and costs are expected to rise at the inflation rate of 2.0% per year over the duration of the project. Other than sales and costs of goods sold, all costs are incurred uniformly throughout the year.

Cost of Financing

Magnum’s has a corporate cost of capital equal to 10.0%. It is expected that the electric cars project will have a similar risk level as the project is directed at the same customers and is influenced in a similar manner by the business cycle. The solar generator project’s cost of capital is 13.0% given the more cyclical nature of the construction industry and the high level of global competition. In addition, as this is a venture into a new product area, Magnum’s policy is to raise the cost of capital by 3.0% to reflect greater project risk. The corporate tax rate is 30%.

• Calculate the NPV, IRR, and discounted payback period for the electric cars and solar generator projects. Use the nominal approach.
• Using Excel’s Data Table feature, determine the change in NPV for each project if the actual RRR was 5.0% lower or 5.0% higher than the rate specified rate in intervals of 1.0%.
• Which project(s) should Magnum pursue? Explain.

Financial Management Copyright © by Dan Thompson is licensed under a Creative Commons Attribution 4.0 International License , except where otherwise noted.

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• HR & Payroll

What is Capital Budgeting? Process, Methods, Formula, Examples

‘Expansion and Growth’ are the two common goals of an organization's operations. In case a company does not possess enough capital or has no fixed assets , this is difficult to accomplish. It is at this point that capital budgeting becomes essential.

The capital budget is used by management to plan expenditures on fixed assets. As a result of the budgets, the company's management usually determines which long-term strategies it can invest in to achieve its growth goals. For instance, management can decide if it needs to sell or purchase assets for expansion to accomplish this.

The purpose of capital budgeting is to make long-term investment decisions about whether particular projects will result in sustainable growth and provide the expected returns.

We shall learn about Capital Budgeting and all the details related to it in this article:

• What is Capital Budgeting in detail
• Features of capital budgeting
• Understanding capital budgeting and how it works
• Techniques/Methods of capital budgeting with Examples
• Process of capital budgeting
• Factors affecting capital budgeting
• Limitations of capital budgeting

What is Capital Budgeting?

Capital Budgeting is defined as the process by which a business determines which fixed asset purchases or project investments are acceptable and which are not. Using this approach, each proposed investment is given a quantitative analysis, allowing rational judgment to be made by the business owners.

Capital asset management requires a lot of money; therefore, before making such investments, they must do capital budgeting to ensure that the investment will procure profits for the company. The companies must undertake initiatives that will lead to a growth in their profitability and also boost their shareholder’s or investor’s wealth.

Features of Capital Budgeting

Capital Budgeting is characterized by the following features:

• There is a long duration between the initial investments and the expected returns.
• The organizations usually estimate large profits.
• The process involves high risks.
• It is a fixed investment over the long run.
• Investments made in a project determine the future financial condition of an organization.
• All projects require significant amounts of funding.
• The amount of investment made in the project determines the profitability of a company.

Understanding Capital Budgeting

While companies would like to take up all the projects that maximize the benefits of the shareholders, they also understand that there is a limitation on the money that they can employ for those projects. Therefore, they utilize capital budgeting strategies to assess which initiatives will provide the best returns across a given period. Owing to its culpability and quantifying abilities, capital budgeting is a preferred way of establishing if a project will yield results.

To measure the longer-term monetary and fiscal profit margins of any option contract, companies can use the capital-budgeting process. Capital budgeting projects are accepted or rejected according to different valuation methods used by different businesses. Under certain conditions, the internal rate of return (IRR) and payback period (PB) methods are sometimes used instead of net present value (NPV) which is the most preferred method. If all three approaches point in the same direction, managers can be most confident in their analysis.

How Capital Budgeting Works

It is of prime importance for a company when dealing with capital budgeting decisions that it determines whether or not the project will be profitable. Although we shall learn all the capital budgeting methods, the most common methods of selecting projects are:

• Payback Period (PB)
• Internal Rate of Return (IRR) and
• Net Present Value (NPV)

It might seem like an ideal capital budgeting approach would be one that would result in positive answers for all three metrics, but often these approaches will produce contradictory results. Some approaches will be preferred over others based on the requirement of the business and the selection criteria of the management. Despite this, these widely used valuation methods have both benefits and drawbacks.

Investing in capital assets is determined by how they will affect cash flow in the future, which is what capital budgeting is supposed to do. The capital investment consumes less cash in the future while increasing the amount of cash that enters the business later is preferable.

Keeping track of the timing is equally important. It is always better to generate cash sooner than later if you consider the time value of money. Other factors to consider include scale. To have a visible impact on a company's final performance, it may be necessary for a large company to focus its resources on assets that can generate large amounts of cash.

In smaller businesses , a project that has the potential to deliver rapid and sizable cash flow may have to be rejected because the investment required would exceed the company's capabilities.

The amount of work and time invested in capital budgeting will vary based on the risk associated with a bad decision along with its potential benefits. Therefore, a modest investment could be a wiser option if the company fears the risk of bankruptcy in case the decisions go wrong.

Sunk costs are not considered in capital budgeting.  The process focuses on future cash flows rather than past expenses .

Techniques/Methods of Capital Budgeting

In addition to the many capital budgeting methods available, the following list outlines a few by which companies can decide which projects to explore:

#1 Payback Period Method

It refers to the time taken by a proposed project to generate enough income to cover the initial investment. The project with the quickest payback is chosen by the company.

Example of Payback Period Method:

An enterprise plans to invest $100,000 to enhance its manufacturing process. It has two mutually independent options in front: Product A and Product B. Product A exhibits a contribution of $25 and Product B of $15. The expansion plan is projected to increase the output by 500 units for Product A and 1,000 units for Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

The Payback Period for Product A is calculated as:

Product A = 100,000 / 12,500 = 8 years

Now, the  Payback Period for Product B is calculated as:

Product B = 100,000 / 15,000 = 6.7 years

This brings the enterprise to conclude that Product B has a shorter payback period and therefore, it will invest in Product B.

Despite being an easy and time-efficient method, the Payback Period cannot be called optimum as it does not consider the time value of money. The cash flows at the earlier stages are better than the ones coming in at later stages. The company may encounter two projections with the same payback period, where one depicts higher cash flows in the earlier stages/years. In such as case, the Payback Period may not be appropriate.

A similar consideration is that of a longer period, potentially bringing in greater cash flows during a payback period. In such a case, if the company selects the projects based solely on the payback period and without considering the cash flows, then this could prove detrimental for the financial prospects of the company.

#2 Net Present Value Method (NPV)

Evaluating capital investment projects is what the NPV method helps the companies with. There may be inconsistencies in the cash flows created over time. The cost of capital is used to discount it. An evaluation is done based on the investment made. Whether a project is accepted or rejected depends on the value of inflows over current outflows.

This method considers the time value of money and attributes it to the company's objective, which is to maximize profits for its owners. The capital cost factors in the cash flow during the entire lifespan of the product and the risks associated with such a cash flow. Then, the capital cost is calculated with the help of an estimate.

Example of Net Present Value (with 9% Discount Rate ):

For a company, let’s assume the following conditions:

Capital investment = $10,000

Expected Inflow in First Year = $1,000

Expected Inflow in Second Year = $2,500

Expected Inflow in Third Year = $3,500

Expected Inflow in Fourth Year = $2,650

Expected Inflow in Fifth Year = $4,150

Discount Rate = 9%

Net Present Value achieved at the end of the calculation is:

With 9% Discount Rate  = $18,629

This indicates that if the NPV comes out to be positive and indicates profit. Therefore, the company shall move ahead with the project.

#3 Internal Rate of Return (IRR)

IRR refers to the method where the NPV is zero. In such as condition, the cash inflow rate equals the cash outflow rate. Although it considers the time value of money, it is one of the complicated methods.

It follows the rule that if the IRR is more than the average cost of the capital, then the company accepts the project, or else it rejects the project. If the company faces a situation with multiple projects, then the project offering the highest IRR is selected by them.

We shall assume the possibilities exhibited in the table here for a company that has 2 projects: Project A and Project B.

Here, The IRR of Project A is 7.9% which is above the Threshold Rate of Return (We assume it is 7% in this case.) So, the company will accept the project. However, if the Threshold Rate of Return would be 10%, then it would be rejected as the IRR would be lower. In that case, the company will choose Project B which shows a higher IRR as compared to the Threshold Rate of Return.

#4 Profitability Index

This method provides the ratio of the present value of future cash inflows to the initial investment. A Profitability Index that presents a value lower than 1.0 is indicative of lower cash inflows than the initial cost of investment. Aligned with this, a profitability index great than 1.0 presents better cash inflows and therefore, the project will be accepted.

Assuming the values given in the table, we shall calculate the profitability index for a discount rate of 10%.

So, Profitability Index with 10% discount = $15,807/$10,000  = 1.5807

As per the rule of the method, the profitability index is positive for the 10% discount rate, and therefore, it will be selected.

Process of Capital Budgeting

The process of Capital Budgeting involves the following points:

Identifying and generating projects

Investment proposals are the first step in capital budgeting. Taking up investments in a business can be motivated by a number of reasons. There could be the addition or expansion of a product line. An increase in production or a decrease in production costs could also be suggested.

Evaluating the project

It mainly consists of selecting all criteria necessary for judging the need for a proposal. In order to maximize market value, it has to match the company's mission. It is crucial to consider the time value of money here.

In addition to estimating the benefits and costs, you should weigh the pros and cons associated with the process. There could be a lot of risks involved with the total cash inflows and outflows. This needs to be scrutinized thoroughly before moving ahead.

Selecting a Project

Since there is no ‘one-size-fits-all’ factor, there is no defined technique for selecting a project. Every business has diverse requirements and therefore, the approval over a project comes based on the objectives of the organization.

After the project has been finalized, the other components need to be attended to. These include the acquisition of funds which can be explored by the finance department of the company. The companies need to explore all the options before concluding and approving the project. Besides, the factors like viability, profitability, and market conditions also play a vital role in the selection of the project.

Implementation

Once the project is implemented, now come the other critical elements such as completing it in the stipulated time frame or reduction of costs. Hereafter, the management takes charge of monitoring the impact of implementing the project.

Performance Review

This involves the process of analyzing and assessing the actual results over the estimated outcomes. This step helps the management identify the flaws and eliminate them for future proposals.

Factors Affecting Capital Budgeting

So far in the article, we have observed how measurability and accountability are two primary aspects that achieve the center stage through capital budgeting. However, while on the path to accomplish a competent capital budgeting process, you may come across various factors that may affect it.

Let us move on to observing the factors that affect the capital budgeting process.

Objectives of Capital Budgeting

The following points present the objectives of the capital budgeting:

• Capital Expenditure Control : Organizations need to estimate the cost of investment as it allows them to control and manage the required capital expenditures.
• Selecting Profitable Projects : The company will have to select the most appropriate project from the multiple possibilities in front of it.
• Identification of Source of funds : The businesses need to locate and select the most viable and apt source of funds for long-term capital investment. It needs to compare the various costs like the costs of borrowing and the cost of expected profits.

Limitations of Capital Budgeting

Although capital budgeting provides a lot of insight into the future prospects of a business, it cannot be termed a flawless method after all. In this section, we learn about some of the limitations of capital budgeting.

It is a simple technique that determines if an enhanced value of a project justifies the required investment. The primary reason to implement capital budgeting is to achieve forecasting revenue a project may possibly generate. The problem could be the estimate itself. All the upfront costs or the future revenue are all only estimates at this point. An overestimation or an underestimation could ultimately be detrimental to the performance of the business.

Time Horizon

Usually, capital budgeting as a process works across for long spans of years. While the shorter duration forecasts may be estimated, the longer ones are bound to be miscalculated. Therefore, an expanded time horizon could be a potential problem while computing figures with capital budgeting.

Besides, there could be additional factors such as competition or legal or technological innovations that could be problematic.

The payback period method of capital budgeting holds a lot of relevance, especially for small businesses. It is a simple method that only requires the business to repay in the predecided timeframe. However, the problem it poses is that it does not count in the time value of money. This is to say that equal amounts (of money) have different values at different points in time.

Discount Rates

The accounting for the time value of money is done either by borrowing money, paying interest, or using one’s own money. The knowledge of discount rates is essential. The proper estimation and calculation of which could be a cumbersome task.

Even if this is achieved, there are other fluctuations like the varying interest rates that could hamper future cash flows. Therefore, this is a factor that adds up to the list of limitations of capital budgeting.

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Key Takeaways

Before we wrap up the post, let us peep into the important points with context to Capital Budgeting:

• Capital Budgeting is defined as the process by which a business determines which fixed asset purchases are acceptable and which are not.
• Capital budgeting leads to calculating the profitable capital expenditure.
• Determining if replacing any existing fixed assets would yield greater returns is a part of capital budgeting
• Selecting or denying a given project is based on its merits.
• The process of capital budgeting requires calculating the number of capital expenditures.
• An assessment of the different funding sources for capital expenditures is needed.
• Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.
• The process of capital budgeting involves the steps like Identifying the potential projects, evaluating them, selecting and implementing the projects, and finally reviewing the performance for future considerations.
• Capital return, accounting methods, structures of capital, availability of funds, and working capital are some of the factors that affect the process of capital budgeting.

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Capital Budgeting: Definition, Methods, and Examples

What Is Capital Budgeting?

Capital budgeting is a process that businesses use to evaluate potential major projects or investments. Building a new plant or taking a large stake in an outside venture are examples of initiatives that typically require capital budgeting before they are approved or rejected by management.

As part of capital budgeting, a company might assess a prospective project's lifetime cash inflows and outflows to determine whether the potential returns it would generate meet a sufficient target benchmark. The capital budgeting process is also known as investment appraisal.

Key Takeaways

• Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. 
• The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark.  
• The major methods of capital budgeting include discounted cash flow, payback analysis, and throughput analysis.

Investopedia / Lara Antal

How Capital Budgeting Works

Ideally, businesses could pursue any and all projects and opportunities that might enhance shareholder value and profit. However, because the amount of capital any business has available for new projects is limited, management often uses capital budgeting techniques to determine which projects will yield the best return over an applicable period.

Although there are a number of capital budgeting methods , three of the most common ones are discounted cash flow, payback analysis, and throughput analysis.

Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project, the mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and other costs.

These cash flows, except for the initial outflow, are discounted back to the present date. The resulting number from the DCF analysis is the net present value (NPV) . The cash flows are discounted since present value assumes that a particular amount of money today is worth more than the same amount in the future, due to inflation.

In any project decision, there is an opportunity cost, meaning the return that the company would have received had it pursued a different project instead. In other words, the cash inflows or revenue from the project need to be enough to account for the costs, both initial and ongoing, but also to exceed any opportunity costs.

With present value , the future cash flows are discounted by the risk-free rate because the project needs to earn that amount at least; otherwise, it wouldn't be worth pursuing.

U.S. Treasury bonds have risk-free rates as they are guaranteed by the U.S. government, making it as safe as it gets.

In addition, a company might borrow money to finance a project and, as a result, must earn at least enough revenue to cover the financing costs, known as the cost of capital . Publicly traded companies might use a combination of debt—such as bonds or a bank credit facility—and equity, by issuing more shares of stock.

The cost of capital is usually a weighted average of both equity and debt. The goal is to calculate the hurdle rate or the minimum amount that the project needs to earn from its cash inflows to cover the costs. To proceed with a project, the company will want to have a reasonable expectation that its rate of return will exceed the hurdle rate.

Project managers can use the DCF model to decide which of several competing projects is likely to be more profitable and worth pursuing. Projects with the highest NPV should generally rank over others. However, project managers must also consider any risks involved in pursuing one project versus another.

Payback analysis is the simplest form of capital budgeting analysis, but it's also the least accurate. It is still widely used because it's quick and can give managers a " back of the envelope " understanding of the real value of a proposed project.

Payback analysis calculates how long it will take to recoup the costs of an investment. The payback period is identified by dividing the initial investment in the project by the average yearly cash inflow that the project will generate.

For example, if it costs $400,000 for the initial cash outlay, and the project generates $100,000 per year in revenue, it will take four years to recoup the investment.

Payback analysis is usually used when companies have only a limited amount of funds (or liquidity) to invest in a project, and therefore need to know how quickly they can get back their investment.

The project with the shortest payback period would likely be chosen. However, the payback method has some limitations, one of them being that it ignores the opportunity cost.

Also, payback analysis doesn't typically include any cash flows near the end of the project's life. For example, if a project that's being considered involves buying factory equipment, the cash flows or revenue generated from that equipment would be considered but not the equipment's salvage value at the conclusion of the project.

As a result, payback analysis is not considered a true measure of how profitable a project is but instead provides a rough estimate of how quickly an initial investment can be recouped.

Throughput Analysis 

Throughput analysis is the most complicated method of capital budgeting analysis, but it's also the most accurate in helping managers decide which projects to pursue. Under this method, the entire company is considered as a single profit-generating system. Throughput is measured as the amount of material passing through that system.

The analysis assumes that nearly all costs are operating expenses, that a company needs to maximize the throughput of the entire system to pay for expenses, and that the way to maximize profits is to maximize the throughput passing through a bottleneck operation.

A bottleneck is the resource in the system that requires the longest time in operations. This means that managers should always place a higher priority on capital budgeting projects that will increase throughput or flow passing through the bottleneck.

What Is the Primary Purpose of Capital Budgeting?

Capital budgeting's main goal is to identify projects that produce cash flows that exceed the cost of the project for a company.

What Is an Example of a Capital Budgeting Decision?

Capital budgeting decisions are often associated with choosing to undertake a new project that will expand a company's current operations. Opening a new store location, for example, would be one such decision for a fast-food chain or clothing retailer.

What Is the Difference Between Capital Budgeting and Working Capital Management?

Working capital management is a company-wide process that evaluates current projects to determine whether they are adding value to the business, while capital budgeting focuses on expanding the current operations or assets of the business.

Capital budgeting is a useful tool that companies can use to decide whether to devote capital to a particular new project or investment. There are several capital budgeting methods that managers can use, ranging from the crude but quick to the more complex and sophisticated.

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Capital budgeting: a systematic review of the literature

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All you need to know about Capital Budgeting

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Latest Update 20 Jan, 2024

Table of content

What is Capital budgeting?

Pay-back period, net present value (npv), internal rate of return (irr) or internal rate of return (tir), average accounting yield, the focus of the investment evaluation, the economic-financial evaluation, the ingredients:, the capital budget in a nutshell.

The modern CFO knows how to govern the process and the tools that allow him to evaluate economic and financial sustainability. The evaluation of investments is not an exclusively strategic judgment but concerns the entire process of creating corporate economic value. This is a reflection shared by managers, aware that the starting point of the creation of economic value for a company is placed in the allocation of capital between the different investment alternatives. Here’s everything you need to know about   capital budgeting .

As part of the planning and control process, a capital budget is a central tool with which management establishes the optimal allocation of financial resources. In short, it is a matter of evaluating alternative   investment projects   to achieve profit levels consistent with the assumed risk profile. It is evident that capital budgeting decisions represent one of the main responsibilities of management, being able, if not taken correctly, to undermine corporate competitiveness. Furthermore, it should be considered that investment analysis is something that does not focus exclusively on industrial projects only, but concerns investment decisions such as the launch of new products, the purchase of shares, shares or securities of different nature or research and advertising projects that impact on the corporate image. Capital budgeting is nothing more than "analysis and evaluation" of the economic returns that could be obtained from the financing of investment projects.

Some classic examples of corporate capital budgeting:

• acquire a new plant that increases business productivity
• finance customers by giving them more credit
• finance a research project
• buy equity securities
• acquire a company
• acquire a corporate brand

For the evaluation of the economic returns of the investments, there are mainly four techniques:

Evaluate the period of time that elapses between the capital advance and the financial return of the same. For example, I spend 100 thousand dollars for a piece of more technologically advanced machinery, and the new productivity allows me a profit increase of 33 thousand dollars per year. In this case, with a bit of approximation, we can say that the payback period is three years.

Adds the incoming and outgoing cash flows in the various years of evaluation of the investment and updates its value by applying a discount rate. It is the most used and reliable one of the four methods.

It derives from the previous method but reasons in reverse. It does not start from a specific discount rate but calculates the discount rate that generates a discounted cash flow zero. The investment is accepted or refused if the discount rate calculated in this way is respectively lower or higher than the degree of risk assigned to the activity to be financed.

The average book yield is calculated by dividing the average annual profits by the value of the average annual book investment.

The possible investment analysis profiles concern the following areas of assessment:

• STRATEGIC, in which consistency with the company competitive profile is verified through the impact on the competitive strength or attractiveness of the business;
• TECHNIQUE, through which the various technological or commercial options are analyzed in terms of effectiveness and efficiency of operations;
• ECONOMIC, which verifies the relationship between the resources absorbed (investment) and those released by the project over time (future benefits) through synthetic indicators;
• FINANCIAL, through which the compatibility of the investment flows with the income and expenses profile is assessed, both from a dimensional and temporal point of view.

A great chef, to make a delicacy, must have first quality ingredients and a recipe that distinguishes him. In the same way, the CFO, to carry out an eco-fin effective evaluation, must have the correct "ingredients" and the right "recipe" with which to combine them.

The ingredients represent the elements to make a choice among the investment alternatives. It is necessary to know them thoroughly. On the other hand, the recipes also indicate the operating methods with which to combine the investment alternatives to reach a synthetic parameter of classification of investment opportunities.

The CFO has five tools that can help him in the choices:

• The invested capital, broken down into three subcategories: ● The declination of the individual types of investment, in the case of a significant articulation of the project, for example, in the construction of the factories; ● This is necessary to have a detail of the useful life of the investments in which the project is divided, so as to be able to derive the depreciation; ● The temporal distribution of investmentsThe secondary costs to be incurred immediately or over the period, so that the investment guarantees its performance during its useful life or within the identified time horizon
• The duration of the investment (time horizon), which leads us to define: ● The time horizon of the investment analysis, which is affected by the sector in which the company operates the type of investment taken into consideration, the predictability of the results, and the economic life of the project. ●  The duration of the periods in which the periodic financial events are to be distributed
• The metric to be used to evaluate the investment. Taking into account that the economic evaluation of investment has as its object, the analysis of the resources absorbed (investment). The project releases them over time (future benefits), the practice uses cash flows, which in this case are identified by the Cash Flow Operating (Operating Free Cash Flow)
• The financial value of time: In finance, it is always associated with the concept of interest rate, which is intended as a "reward" for giving up immediate consumption.
• When evaluating the investments, it must be considered that the cash flows of the project, divided into sub-periods (Fcn), belong to different moments and cannot be added together. Through the discounting process. Therefore, the various amounts will be normalized according to the logic of the financial value of time, thus being able to determine the present value of the profile of future cash flows.
• The discount rate: The theory and practice refer to the opportunity cost of the project, i.e., the return achievable with an equivalent investment in the amount, in the distribution of flows, and in the risk profile. Cost/opportunity that is based on the concept behind finance: the correlation between risk and return.

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From this, we understand how, to determine the value created/destroyed, it is necessary to identify the determinants of the cost of capital, understood as cost/opportunity. Briefly, the key elements through which the cost of corporate capital is determined are:

• the cost of the individual sources of financing, i.e., the cost/opportunity of the shareholders (Ke) and the cost of the interest rate paid to the banks for the credit lines received (Kd)
• the weight of the sources of financing, i.e., the weight as a percentage of the capital contributed by the shareholders (Net Equity / Net Invested Capital) and the weight as a percentage of the capital contributed by the banks (Net Financial Position / Net Invested Capital)

By combining the highlighted elements, we obtain that the cost of capital is determined by the weighted average cost of capital (WACC).

In recent times, many companies are implementing capital budget processes with which to select and monitor investment options. Given that the focus of the capital budget is, under the direction of the CFO, to develop a process of sharing between the management of the rationale for economic-financial sustainability and its feasibility. It is clear that the role of the CFO is to offer its own skills at the service of management.

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Capital Budgeting Questions And Answers

This essay sample essay on Capital Budgeting Questions And Answers offers an extensive list of facts and arguments related to it. The essay’s introduction, body paragraphs and the conclusion are provided below.

1. Why should the required rate of return for a capital budgeting problem be project specific? Doesn’t the firm just have to satisfy an overall cost-of-capital requirement?

Answer: The required rate of return for a capital budgeting problem is project specific because the firm is viewed as a portfolio of projects owned by the shareholders.

It is the shareholder’s perspective that matters, and it is their opportunity cost that gives the required rate of return for a project. The question that the managers should ask is the following: If the shareholders were to receive the cash flows from the project directly, what risk would they associate with the cash flows? Notice that this immediately suggests that the required rate of return should be project specific and that it should reflect the market risk that continues to be present when an investor holds a large, well-diversified portfolio.

International Capital Budgeting Ppt

2. What is the conceptual foundation of the flow-to-equity approach to capital budgeting?

Answer: In the flow-to-equity approach to capital budgeting, the after-tax cash flows that are available to be paid to equity holders are discounted at the levered equity required rate of return. Hence, the interest costs of debt are subtracted from the earnings of the firm in considering the amount of tax the firm will owe, and the interest payments that the firm must make are taken out of the residual free cash flow.

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The discount rate for these levered equity flows therefore must reflect the fact that equity is a residual claimant on the cash flows of the firm.

3. What is the weighted average cost of capital?

Answer: The weighted average cost of capital (WACC) approach to capital budgeting involves forecasting the all-equity free cash flows of the firm and then finding the value of the levered firm by discounting the all-equity free cash flows at an appropriate WACC. It is a one-step procedure for finding the value of the operating assets plus the value of the interest tax shields. The weighted average cost of capital is the weighted sum of the after-tax required rate of return on the firm’s debt and the required rate of return on the firm’s levered equity. The weight for the after-tax rate of return on the firm’s debt is the ratio of the market value of the debt to the market value of total assets. The weight for the rate of return on the firm’s levered equity is the ratio of the market value of the equity to the market value of total assets. Once the total value of the firm is found, the market value of equity is found by subtracting the market value of the debt from the value of the levered firm.

4. Should a firm ever accept a project that has a negative NPV when discounted at the weighted average cost of capital?

Answer: One reason we like the adjusted net present value approach to valuation is that it specifies all of the possible sources of value for a project. The WACC approach works well for projects that will support a certain percentage of leverage and that have no other associated features, such as interest subsidies or growth options that might add value to the project. If the only cash flows from the project are the ones that are being discounted and there are no other sources of value, other than the interest tax shields that are included in the WACC analysis, then the WACC approach finds the market value of the levered project. If this is negative, the project should be rejected.

5. Can you do capital budgeting for a foreign project using a domestic currency discount rate? Explain your answer.

Answer: The answer to the question is yes; you certainly can do capital budgeting for a foreign project using a domestic currency discount rate. You just have to be careful to match the cash flows with the discount rate. One fundamental principle of capital budgeting is that the discount rate should reflect the currency of denomination of the expected cash flows that are being discounted. If a foreign project is providing expected future foreign currency cash flows, these can be discounted to the present using a foreign currency discount rate that reflects the riskiness of the project. The domestic currency present value of this foreign currency present value can then be determined by converting from the present value of foreign currency into the present value of domestic currency using the spot exchange rate. Alternatively, one can generate expected future domestic currency cash flows in future years by converting expected future foreign currency cash flows into expected future domestic currency cash flows using expected future spot exchange rates. These expected future domestic currency cash flows should then be discounted to the present using an appropriate domestic currency discount rate.

6. Why might it be important to use period-specific discount rates when doing capital budgeting?

Answer: We know that risk free spot interest rates are the appropriate discount rates for cash flows from risk free pure discount bonds. If the term structure of spot interest rates is not flat, that is, if it is upward sloping or downward sloping, using the same discount factor for all the cash flows of a risky project will not be correct. If the term structure is upward sloping, and you use the single long-term rate as the base for your risk adjusted discount rate, you will needlessly penalize the earlier cash flows from the project because short-term spot interest rates are lower than long-term spot interest rates. Conversely, if the term structure is downward sloping, and you use the single long-term rate as the base for your risk adjusted discount rate, you will be incorrectly enhancing the value of the earlier cash flows from the project because the short-term interest rates that should be used to discount near-term cash flows are higher than the long-term rates that should be used to discount longer-term cash flows.

7. Why is it necessary to consider forecasts of real currency appreciation and depreciation when doing an international capital budgeting analysis?

Answer: The most important reason to consider forecasts of real currency appreciation or depreciation is that it is likely that a change in the real exchange rate will affect the cash flows of the project. Remember that a real depreciation of the domestic currency makes domestic exporters more profitable and domestic importers less profitable. Also, real appreciations typically reverse themselves somewhat slowly, so that knowledge of the current situation is necessary to know whether the future expected changes in the real exchange rate are going to enhance or detract from the cash flows of the project. Finally, if forecasts of nominal exchange rates are being made with uncovered interest rate parity, these will be somewhat different than forecasts based on relative purchasing power parity. If the market thinks that there will be a real appreciation or depreciation in the future, forecasts of nominal exchange rates based on relative purchasing power parity will not be correct.

8. What is the rate of return on invested capital? How is it calculated?

Answer: The rate of return on invested capital is the free cash flow of the firm divided by the firm’s total assets. If the firm is earning its weighted average cost of capital, the rate of return on invested capital should equal its WACC. If we think of an investment that the firm is making, the rate of return on capital expenditure is the incremental free cash flow divided by the CAPX. Here again, it is important for the firm to do investments in which the rate of return on invested capital equals or exceeded the WACC – otherwise the firm is destroying value.

9. If you borrow a foreign currency, what interest deduction would you receive on your taxes?

Answer: When you borrow in a foreign currency, you get an interest deduction for the domestic currency value of the foreign interest that you pay.

10. If you borrow a foreign currency, are there any capital gains taxes to worry about?

Answer: If you borrow in a foreign currency, there are capital gains taxes to worry about. If the domestic currency has appreciated relative to the foreign currency between when the initial borrowing took place and when the principal is being repaid, it takes less of the domestic currency to repay the foreign currency principal than the amount of domestic currency that you had access to when you borrowed. Thus, you are repaying less than you borrowed and that capital gain is income to you and is taxed by the fiscal authorities. Conversely, if the domestic currency has depreciated relative to the foreign currency between when the initial borrowing took place and when the principal is being repaid, it takes more of the domestic currency to repay the foreign currency principal than the amount of domestic currency that you had access to when you borrowed. Thus, you are repaying more than you borrowed and that capital loss is deductible for tax purposes.

11. Why might a manager accept a high-variance, low-value project instead of a low-variance, high-value project?

Answer: Shareholders only gain in good states of the world, and if the variance of the firm is higher, they gain more in those good states. Holders of debt get paid their full amount in good states of the world, and they get the value of the firm in the bad states of the world. By accepting a high variance project, managers may be able to shift some value from bondholders to shareholders. In such a situation the manager is said to have engaged in asset substitution.

12. Why would a manager not accept a positive net present value project?

Answer: The value of the project accrues to the firm as a whole. Thus, if the firm has risky debt in its capital structure, some of the value of the project will accrue to the bondholders, and the remainder will accrue to the equity holders. The increase in the value of equity may be less than the equity holders must contribute to finance the investment in the project. Hence, a manager acting in the interests of the shareholders would forego such a project. This situation is referred to as an underinvestment problem.

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Capital Budgeting Techniques Research Paper

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Introduction about the topic

Introduction about the company, purpose of research, research questions and methodology of collected data.

Capital budgeting is the process by which companies appraise investment decisions, in particular, by which capital resources are allocated to specific projects. It requires firms to give account for the time value of money and project risk using a variety of more or less formal techniques. The decision to invest in fixed assets is one of the major decisions made by managers.

Investments in fixed assets impact a firm’s operations for a very long time because they involve large capital outlays. As a result, a variety of quantitative and analytical techniques are applied by managers in the selection of projects to enable them to make good decisions in the area 1 .

Capital budgeting comprises of a number of techniques based on various concepts emanating from projects and investments such as the concept of incremental cash flows. Accounting rules play a very important role in the basis of some particular techniques.

The management control process requires the services of budgetary planning and control to provide necessary accounting information. Most of the important information is normally provided through variance reports availed by the accountants in charge. Capital budgeting decisions are influenced by certain factors dealing with economic, social, political, as well as cultural diversity 2 .

There has been tremendous increase in the level of foreign direct investment (FDI) in the last two decades. This has been brought about by the spread of business investment activities across countries of the world. Multinational organisations have faced various challenges due to lack of reliable and accurate methods which could be used in making appropriate decisions within the market place. The paper comprises of various parts the first presenting both theoretical as well as practical overview of the given organisation.

The second part of the reports gives the methodology, including data collection techniques as well as design of questionnaire. Then there are the findings from the research and finally conclusions and recommendations. However, capital budgeting techniques provide measures through which capital budgeting requests are analysed. Net Present Value utilizes the aspect of time value of money concepts, Payback period has been discovered to be deficient of time value techniques 3 .

Capital budgeting is applied in the company’s planning process to determine the status of the firm in line with long term investments 4 . The chamber is one of Saudi Arabia’s oldest and well-established organisations. The promotion of the private sector contribution to the economy is the cause The Chamber is most devoted to.

To that end, it has formulated a lot of services that have significantly helped in development and, especially, promotion with the attempt of giving all the possible support to the beginners of the private sector in such spheres of economy as industry, trade craft and services.

The main aim of the company is to have an active and successful development of Eastern Province private sector activities and to be only one service provider and assistant for the business development in the Eastern Province. The main aim is to provide separate and qualitative services that meet all the requirements the expectation of the private sector, and successful association in the social and economic spheres of life.

The Chamber aims to provide unique and high-quality services that meet the aspirations of the private sector, thus ensuring continuous development through the optimal investment in available resources, renewable technologies and effective participation in the economic and social development of the region; thus realising the wishes of our members in light of the values and principles of our society.

The advancement of the economic growth by means of the full mobilisation of the resources of the private sector to assist the economic development is its final goal.

It aims at promoting the private sector’s origin by means of different steps that include detecting all existing possibilities for the business production, searching for all the possible solutions to different problems that may crop up in the process according to the rules of the system and government programs and working out the plan of the international trade in the attempts of getting the main goals.

The branch expansion has also served as a tool of promoting membership.

The Chamber’s products and services centres around provision of distinct products and services of added value to members, provision of unique preparation and training programs, excellence in the segments of research, studies and information for the purposes of supporting business sector within Eastern Province. Also, they indulge in supporting small and medium enterprises and encouraging innovation and creativity and the culture of self-employment.

Within the last fifty years, the Chamber has been devoted to the private sector in such areas as contact between the business association and the government, promotional agency and of fellowship amongst businesspeople. Provision of a medium for the private sector, allowing them to perform social obligations as well as provision of information on investment opportunities and changes in economic and commercial policies.

The study seeks to examine the various capital budgeting techniques used in Saudi Arabia’s chamber and the various factors influencing financial investment practices within the country. The focus is to find out how capital budgeting is used by Saudi Arabia’s chamber.

Various techniques used in optimising the financial cash flows and at the same time, computation of effective financial rates are covered within the study. There is also the determination on the manner in which capital budgeting should be applied by the use of Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI).

The use of an appropriate type of research design ensured appropriate resolution of the research problem and at the same time help in improving effective level of marketing research. The designs applicable in financial researches always focus on three types of research design which include exploratory research, descriptive research and casual research 5 .

Exploratory research is applicable where general nature of the problem needs to be established. The alternative decisions need to be verified in consideration of relevant variables.

The research methods are characterised by high flexibility and unstructured means granting application of clues concerning the problem situation. Descriptive research involves the use of speculative hypothesis making the relationships not to appear casual and then finally casual research, which seeks to reveal the relationship existing between variables used within the study 6 .

The study involved the use of both descriptive and explanatory, whereby descriptive helped in identifying the value of capital budgeting within Saudi Arabia chamber. And on the other hand, an explanatory approach used to explain the contributions of capital budgeting towards development of corporations within the country.

The research problem can be solved using various methods such as induction and deduction. Inductive approach focuses on obtaining general conclusions from the observations obtained from empirical investigation. The deductive method, on the other hand, utilised the use of hypothesis and theories subject to testing within the empirical world. However, the more preferable way through this research was the use of abduction method. This method incorporates both empirical and theoretical measures.

The study discussed much on theories and frameworks based on capital budgeting framework used in the analysis of the various corporations within the chamber. The study also required to establish and identify capital budgeting intangibles which need the application of observations from empirical studies for the purposes of deducing some assumptions. Hence most of the study focused on abduction method 7 .

The following procedures were incorporated in the solution of the research problems involved. Secondary literature was obtained from books, journals, internet as well as electronic databases. This provided the required literature used in establishing a theoretical framework necessary for the study.

The empirical study involved the use of mail survey, where the survey was conducted amongst various corporations within the private and public sector through the use of detailed questionnaire. This was done in order to establish the various methods of restructuring and work design the chamber uses for international markets 8 .

It is widely accepted that the best way to evaluate capital budgeting proposals are the discounted cash flow methods. More recent studies suggest that firms are increasingly adopting discounted cash flow analysis, although this was not always the case in the past. Much of the empirical research on capital budgeting practices adopted by corporate managers are always drawn from US data research based on different countries is also done by other authors.

An appraisal in the application of the capital budgeting in the retail sector was undertaken in the Kingdom of Saudi Arabia as a basis for strategic capital budgeting for the purposes of developing this study. The focus of the study was to address the extent of use of capital budgeting in retail sector in the kingdom of Saudi Arabia in terms of using financial and accounting tools, sales forecast, external factors, benchmarking and feedback mechanism.

It also sought to establish the extent to which capital budgeting is applied in retail sector in the Kingdom of Saudi Arabia. This further established employee empowerment, negative effect of branch sales, comparison and application of standard budget for new companies within the SA chamber.

Random sampling was used to obtain data, where both private and public companies within Saudi Arabia were chosen at random for the mail survey. Then the statistical analysis was used to analyse and interpret data from questionnaires.

Empirical results

Capital budgeting of SA chamber presents one of the most important means of making decisions. Capital budgeting is necessary for the purposes of maximising shareholder wealth. The empirical results are presented, and the analysis is given based on the data obtained.

The study provided participants from the chamber with relevant techniques allowing them to tick various importances of capital budgeting techniques from the questionnaire given. The companies from both private and public sector that were sampled added up to 124; however, responses were received from only 60 representing 48% response rate. Good percentage of the questionnaires was answered by intended respondents from the chamber.

Table1: showing the response rate

Respondents were found to be learned since they had considerable academic qualifications. This indicated that they had valuable information concerning the area of study. The size of the capital budget was also identified from each respondent and tabulated as below. The companies within private and public sector differ in terms of size hence vary in annual capital budget.

There were also responses on the frequency of the use of the various budgeting methods. These include; net present value (NPV), profitability index (PI), Internal rate of return (IRR), modified internal rate of return (MIRR) as well as payback. The results were as follows 9 .

Table: Capital Budgeting Techniques

The results indicate that the techniques mostly used in evaluation of projects within Saudi Arabia Chamber are net present value and internal rate of return. This is clearly shown by 94% preferring the use of NPV, 90% of the companies use IRR in most occasions while 70% of the participants use payback period method. This reveals that NPV, payback period, IRR are the most preferred techniques with NPV and IRR forming the most popular methods.

Table showing number of techniques used by companies within chamber

The findings from the table revealed that most companies use multiple budgeting techniques in the process of evaluating their projects. The survey revealed that around 46% of the participants use less than three techniques while the rest utilize more than three techniques.

Table showing significance differences of importance between Capital Budgeting Techniques

The table above represents ranking of techniques based on their importance value attached by the companies. The ranking places NPV, IRR and Payback at the top of the table showing their level of importance. The results reveal some significant differences between participants based on the importance of the capital budget techniques. Most of the companies rank NPV as the most important technique used in evaluating projects.

The objectives of the study were eventually met despite the shortcomings encountered. The results revealed the various capital budgeting techniques and how they are utilized by various companies. This gives vital information to companies concerning the best financial strategies applicable within the current market environment.

Limitations and recommendations

There were various limitations to this study which included the sample group used in the survey which was only 60 companies within the Saudi Arabia Chamber. This means that more data is required so as to establish the exact trend from both lowly ranked and highly ranked companies in private and public sectors.

This would enable adequate understanding on the nature of capital budgeting technique used and the associated impacts on Saudi Arabia chamber. There was high possibility that local meanings of the techniques were lost during the translation process. There were instances where some companies could not allow their capital budgeting practice to be published for the fear of being miss-interpreted.

Based on the study’s findings, the following recommendations are proposed: the owners and management of retail family establishments should use these three elements in the preparation of capital budget; Financial statement or profit and loss statement, Cash flow and Balance sheet. They should also empower employees to help them prepare estimates of their cash flow in terms of sales forecast using data gathered from other reliable sources.

They should employ management tools such as the break-even analysis, payback analysis, net present value and internal rate of return. The organisation at the same time should consider external factors such as government regulations, price increases, stiff competition and customer’s needs. Multiple sales assumptions should be used along with a standard budget. Comparison of different projects within the organisation should also be done.

Adrian B, International Capital Budgeting , 3th edition, Simon, NY, 1996

Dayananda D, R Irons, J Herbohn & P Rowland, Financial appraisal of investment projects. Capital Budgeting . Pitt, New York, 2002

Gray SJ, SB Salter & LH Radebaugh, Global Accounting and Control: A Managerial Emphasis, John Wiley and Sons, London, 2001

Leedy, PD & JE Ormrod, Practical Research Planning and Design . 8th ed. Pearson Prentice-Hall, New Jersey, 2005

Modigliani, F &M Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment”. American Economic American Economic Review , Vol 48 no3, 2003, pp 261–297

1 B Adrian, International Capital Budgeting , 3th edition, Simon, NY, 1996

2 SJ Gray et al, Global Accounting and Control: A Managerial Emphasis, John Wiley and Sons, London, 2001

3 D Dayananda et al, Financial appraisal of investment projects. Capital Budgeting . Pitt, New York, 2002

5 PD Leedy & JE Ormrod, Practical Research Planning and Design . 8th ed. Pearson Prentice-Hall, New Jersey, 2005

8 PD Leedy & JE Ormrod, Practical Research Planning and Design

9 F Modigliani, &M Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment”, American Economic American Economic Review , Vol 48 no.3, 2003, pp 261–297

• How to Manage Budget Hotels - Cases in London
• Local Government Budgets: the City of Philadelphia
• Corporate Finance and Investment Appraisal Methods
• The Modified Internal Rate of Return
• Interest Rate Risk Management and Financial Derivatives
• Alpine Wear’s Cash Budget
• Overview of the Budget
• Budget Deficit: Our Nations Budget Deficit and How It Relates to Economic Theory and Crisis
• Capital Budgeting Projects
• Budget Forecasting and Its Importance in Planning
• Chicago (A-D)
• Chicago (N-B)

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Capital Budgeting essay

Capital budgeting comprises an integral part of the effective business development because companies have to focus on the most prospective and profitable projects with the balanced risk-returns ratio. Capital budgeting is the process, which determines whether the particular project is worth pursuing. Investing too much into capital budgeting leads to the narrow development of the company with the focus on a few secure and profitable projects, while others projects may remain under-estimated and the company can fail to invest into a risky but potentially successful project. Investing too little into capital budgeting can raise the problem of the low effectiveness of company’s investments, if the company fail to determine priority projects which are the most prospective and beneficial for its further business development.

Sunk costs are costs that cannot be changed and are irrelevant to the decision making process because they are the past costs that have been already spent but currently the equipment, machinery or other items purchased are virtually useless. Opportunity costs are costs involving the alternative chosen that has brought profits to the company. In contrast to sunk costs, which brought financial losses to the company, opportunity costs bring profits. However, both opportunity and sunk costs have ceased their impact and cannot be used anymore.

Capital budgeting is associated with three types of risks, including stand-alone risk, corporate risk, and market risk. Stand-alone risk is the risk associated with a particular project and means that the company faces a high risk of the failure of completing the particular project successfully. The corporate risk implies that the entire company is at risk and its business operations are under a threat. Therefore, the company may face a risk of losing its marketing position or even run bankrupt. As for the market risk, this is the risk associated with the possible downturn or crisis within the market, as was the case of the housing market in the US in 2007-2008. Each type of risk is necessary to assess and control because the failure to identify either risk may lead to the failure of the project.

The qualitative risk focuses on the assessment of actual risks associated with a particular project or company. However, the qualitative risk is subjective because it relies on the assessment of qualitative attributes and does not involve quantitative ones. Nevertheless, this risk is essential to assess to understand prospects and risks associated with a particular project to the full extent. The qualitative risk focuses on the assessment of the particular project and related risks from the qualitative standpoint that means that the assessment involves the analysis of the qualitative information related to the project and associated risks. As a result, the company conducting the assessment of the qualitative risk can determine whether the project is worth implementing or not. For example, the introduction of a new product is accompanied by the qualitative risk assessment. The company monitors the customer behavior and conducts interviews of a group of customers to assess the qualitative risk. On the ground of their responses, the company makes conclusion concerning the risk. Obviously, such risk assessment is subjective because it is grounded on subjective responses of customers. Nevertheless, such risk assessment helps to understand better real world prospects of a particular project.

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