This concluding chapter introduces the basic concepts and practices associated with capital budgeting. Capital budgets help managers evaluate and prioritize competing capital investment opportunities. Unlike recurring operating expenses—such as insurance premiums, payroll obligations, and property taxes—capital investments refer to large financial resource allocations having long-term consequences. Examples include purchases of manufacturing equipment, replacements of aircraft, launches of new product lines, and acquisitions of other companies. Once a capital investment has been made, it is difficult—if not impossible—to reverse the decision. Thus, it is essential that managers engage in rigorous analyses and make realistic projections about the potential impact of every capital investment decision.
Capital budgeting shares similarities with the long-term forecasting techniques illustrated in Chapter 5. However, the forecasts made in Chapter 5 pertained to activities of entire businesses in the aggregate. Moreover, the projections made in Chapter 5 culminated in a complete set of forecasted financial statements used to predict a company’s profitability, solvency, and liquidity. Capital budgeting does not focus upon entire businesses in the aggregate; rather, it focuses only upon variables that are expected to change incrementally as a result of making a specific capital investment. In other words, capital budgeting examines how certain key variables—such as sales, expenses, net income, and working capital—are likely to change as a direct result of making a particular capital investment.1 Forecasted changes in these key variables are used to generate cash flow estimates required for measuring an investment’s financial viability. The payback period, net present value (NPV), and internal rate of return (IRR) are the most common capital budgeting measures used to assess the desirability of a potential investment opportunity.
The Capital Budgeting Process
The only capital budgeting variable known with certainty is the initial cost of a particular investment. Everything from that point forward is based on assumptions and forecasts that span many years. Thus, the stakes are high and the potential for downside risk is considerable. Although far from foolproof, capital budgeting provides a framework for navigating these uncharted waters.
Imagine a capital investment as a $1 million seed with the potential to grow into a fruitful money tree. Once purchased, there is no turning back. The $1 million seed is planted, and additional resources are consumed each year to water and fertilize it. The seed germinates and sprouts, and over time a money tree produces an abundance of leaves in the form of cash. As the cash falls to the ground at the end of each year, it is put into large plastic bags, taken inside, and counted. After many years, the tree grows old and dies.
For the seed to be considered a good investment it must yield enough cash to recover its $1 million cost plus provide a reasonable return on investment before the money tree perishes. The capital budgeting process assesses the likelihood that the seed will germinate and be fruitful, projects how quickly the seed’s $1 million cost will be recouped, and determines how much cash in excess of the initial $1 million investment is a reasonable return expectation. Figure 8.1 provides a model for conceptualizing the general framework of the capital budgeting process. A brief discussion of the model’s sequential elements is necessary before providing a comprehensive illustration.
Figure 8.1 The capital budgeting process
Determine the Initial Capital Investment Cost
In most circumstances, the actual cost of a capital investment is known. It generally includes all costs considered reasonable and necessary for an investment to begin serving its intended purpose. These costs typically include a negotiated acquisition price, sales taxes, delivery costs, site preparation, and training and testing costs. The initial cost of any capital investment is analogous to the $1 million seed required to grow a money tree.
The reliability of any forecasting model depends highly on formulating reasonable expectations about the future. Perhaps the most critical step in the capital budgeting process is articulating a general set of reliable assumptions associated with a capital investment’s potential financial impact. These assumptions often include the:
- Estimated life of the investment;
- Depreciation or amortization associated with the investment;
- Incremental sales that the investment is expected to generate;
- Incremental costs expected to be incurred as a result of making the investment;
- Anticipated rate of inflation and how it will impact incremental revenue and expenses;
- Estimated tax rate expected to be in effect over the life of the investment;
- Incremental debt and equity financing needed to acquire the investment;
- Incremental changes in various working capital accounts expected to occur over the life of the investment;
- Liquidation proceeds—if any—anticipated from the future sale or disposal of the investment.
Prepare Incremental Income Forecasts
All capital investment decisions require that management forecast how an investment will affect incremental income. Again, the capital budgeting process is not concerned with a company’s overall performance in the aggregate; rather, it focuses only upon variables that are expected to change incrementally as a result of making a specific investment. Thus, incremental income forecasts are estimates of how a particular capital investment is expected to impact a company’s income over time.
Prepare Incremental Cash Flow Forecasts
Once incremental income forecasts have been made, they are converted into incremental cash flow forecasts in the same way that net income was converted to cash flow from operating activities using the indirect method illustrated in Chapter 5. The conversion process involves adding back depreciation and adjusting net income up or down in response to anticipated changes in accounts receivable, inventory, trade payables, and other relevant accounts. Forecasting a capital investment’s incremental cash flow is illustrated later in the chapter.
Compute and Interpret the Payback Period, NPV, and IRR
As mentioned previously, the payback period, NPV, and IRR are the most common capital budgeting measures used to assess desirability of a potential investment opportunity. Each of these measures is computed using incremental cash flow forecasts. Estimating an investment’s payback period is a rather straightforward endeavor, whereas NPV and IRR require an understanding of the time-value of money.
The Time-Value of Money
If given an option to receive $10,000 today, or wait 5 years to receive the same amount, most rational people will opt to receive the cash sooner rather than later. The reason for their preference is that money has a time-value—meaning that a dollar received today is of more value to someone than a dollar to be received in the future—so the prospect of receiving $10,000 right now is more desirable than the prospect of receiving the same amount next month, next year, or 5 years from now. In fact, the longer someone must wait to receive a dollar, the less value they will place on the prospect of receiving it.
Money has a time-value because the sooner a dollar is received the more quickly it can be invested to generate additional dollars. If given an option to receive $9,520 today or $10,000 five years from now, most people will opt to have the lesser amount today, because by investing the $9,520 at an annual return of just 1 percent, it will grow to more than $10,000 in 5 years. However, if given an option to receive $4,020 today or $10,000 five years from now, most will opt to wait for the larger amount, because unless the $4,020 can be invested to earn a minimum annual return of 20 percent, it will be worth less than $10,000 in 5 years.2
Time-value-of-money concepts play a key role in the capital budgeting process. Managers must forecast the cash flows that a capital investment is expected to generate, estimate the timing of those cash flows, and determine the minimum return that an investment opportunity must yield for it to be considered acceptable. The importance of understanding time-value-of-money concepts, and how these concepts influence capital investment decisions, is illustrated in the following section.
The Case of Satka Manufacturing
Satka Manufacturing supplies the automobile industry with electrical components used in onboard GPS navigation systems. Due to an industry-wide slowdown, one of the company’s production facilities is currently idle. Satka recently received a contract proposal from the Department of Defense to produce a component for a top-secret military weapon. The contract spans 4 years and requires an investment in a highly specialized piece of production equipment. Military officials will dispose of the equipment at the end of the 4-year project, and the contract guarantees Satka a $49,000 salvage value. The equipment has no alternative uses, and Satka must surrender it when the contract terminates.
To determine the viability of the proposal, Satka’s required investment in the specialized production equipment will be evaluated using the capital budgeting process diagramed in Figure 8.1. Each step of the process is highlighted in the following discussion.
Initial Investment Cost
The base cost of the specialized equipment is $600,000; however, site preparation and testing procedures will cost an additional $25,000. Thus, the total cost of the investment is $625,000. If Satka agrees to accept this contract, it will purchase the equipment with its cash reserves to avoid any incremental financing costs.
General Assumptions
The contract requires the Department of Defense to pay for all orders prior to shipment. Thus, Satka’s accounts receivable are not anticipated to change incrementally over the term of the contract. Satka will produce only the number of units specified for each order, and each order will be shipped immediately upon completion to avoid any warehousing costs. Moreover, raw material deliveries will be placed immediately into production, and all vendors will be paid within days. As such, no incremental changes to inventory levels or trade payables are anticipated over the term of the contract.
For capital budgeting purposes, the equipment’s depreciation will be based on the MACRS method used by Satka for federal income tax purposes.3 The depreciation deductions allowed by the Internal Revenue Code for this particular category of specialized equipment are presented in Figure 8.2. Note that each year’s allowable deduction is specified as a percentage of the investment’s initial cost.
Figure 8.2 MACRS depreciation deductions
Incremental sales over the 4-year project are projected to be $700,000 in Year-1, $800,000 in Year-2, $900,000 in Year-3, and $850,000 in Year-4. Incremental variable costs are expected to remain constant at 30 percent of sales, and will consist primarily of labor, materials, and energy costs. Incremental fixed costs are expected to be $260,000 in the first year of the contract, and increase each year by a projected rate of inflation of 3 percent. Incremental fixed expenditures will be composed primarily of increased security costs, additional IT support, and higher insurance premiums. Satka’s income tax rate is expected to remain constant at 40 percent throughout the contract period.
Incremental Income Forecasts
Satka’s incremental income projections are provided in Figure 8.3. These projections are consistent with the terms of the contract and management’s assumptions.
Figure 8.3 Incremental income projections
At first glance, incremental income projections appear to be very strong, especially in Year-3 and Year-4. Income forecasts are much lower in Year-1 and Year-2, due to the large depreciation deductions allowed by the Internal Revenue Code in the first 2 years of the contract. Notice how much lower Satka’s income tax projections are in the first 2 years of the project compared to the last 2 years. Being able to deduct so much of the equipment’s cost so quickly, and thereby reduce income taxes so significantly, is the primary benefit of using MACRS for tax purposes.4
Incremental Cash Flow Forecasts
The incremental cash flow projections shown in Figure 8.4 were derived by adjusting the incremental net income amounts computed in Figure 8.3.
Figure 8.4 Incremental cash flow projections
As discussed previously, Satka does not anticipate any changes in its working capital accounts—accounts receivable, inventory, or trade payables—so the only required adjustments to net income are adding back annual depreciation expense, and including the equipment’s $49,000 disposal proceeds at the end of the 4-year contract.5 Notice that net cash flows in the first two years of the contract are significantly greater than the net income projections once the disproportionally large depreciation deductions allowed under the Internal Revenue Code are added back.
The contract’s projected incremental cash flow over the 4-year period totals $1,011,354, which exceeds the required $625,000 equipment investment by $386,354. The final step of the capital budgeting process is determining whether the $386,354 net benefit is reasonable, given the inherent risks associated with this particular project.
As noted previously, the payback period, NPV, and IRR are the most common capital budgeting measures used to assess whether the potential benefits of an investment opportunity reasonably compensate the investor for risk. Satka’s potential investment in specialized equipment will illustrate each of these capital budgeting measures.
The Payback Period
Although the incremental 4-year cash flow of Satka’s contract is expected to exceed its initial investment cost by $386,354, it is important to estimate how quickly the cost of the investment will be recovered. The amount of time that it takes for an investment to pay for itself is called the payback period. Generally speaking, once an investment’s cost has been fully recovered, any unforeseen negative circumstances are potentially less damaging than when they occur before recouping the investment’s cost. Thus, investments with relatively short payback periods are considered safer—less risky—than those with long payback periods.6
Using the incremental cash flow estimates developed in Figure 8.4, the projected payback period for Satka’s required investment in specialized equipment is 2.49 years, as illustrated in Figure 8.5.
Figure 8.5 The payback period
Figure 8.5 reveals that the investment’s total incremental cash flow after two full-years is expected to be $505,820 ($220,500 in Year-1, plus $285,320 in Year-2). Thus, only $119,180 of incremental cash flow is required in Year-3 to recover the equipment’s $625,000 initial cost. If the net cash flow from this project is to be received at a constant linear rate throughout Year-3, dividing the $119,180 Year-3 requirement by Year-3’s $245,000 estimated cash flow suggests that the equipment’s cost will be recovered about half-way through the year ($119,180 ÷ $245,000 = 49%). Thus, its payback period is 2.49 years (two full-years, plus 49 percent of a year).
Estimating an investment’s payback period is an important part of the capital budgeting process; however, it treats all cash flows equally—regardless of their timing—and thereby ignores that money has a time-value. As discussed previously, Satka should take into consideration that dollars received toward the end of the contract are of less value than dollars received in earlier years.
NPV and IRR
Both NPV and IRR take the time-value of money into consideration. To compare the $625,000 investment required at the beginning of the contract to cash flows forecasted over the contract’s 4-year term, future cash flows must be discounted by applying an appropriate discount rate. The discount rate used is equivalent to the rate of return required to compensate a company for risk. The higher the perceived risk associated with any capital investment, the more its future cash flows will be discounted, and the lower its discounted present value will be. The lower the perceived risk associated with a capital investment, the less its future cash flows will be discounted, and the higher its discounted present value will be.7 Satka perceives that this particular project is highly risky for a variety of reasons:
- Developing components for military weapons increases the likelihood of security threats and security breaches.
- If the automobile manufacturing industry rebounds, Satka will be unable to use its production facility to fulfill increased orders for GPS components.
- Satka’s board of directors is not particularly enthusiastic about the company diversifying its offerings to include components used in military weapons.
For most capital investments, Satka’s management rarely uses a discount rate in excess of 15 percent to compensate the company for risk. However, it perceives the investment risk of this particular project so great that it must have the potential to generate a minimum rate of return of 20 percent for it to be acceptable. Thus, its projected incremental cash flows will be discounted at a rate of 20 percent.
The discounted present value of the future cash flows from Satka’s required investment—discounted at 20 percent—is diagramed in Figure 8.6. All of the figures in this diagram were computed effortlessly by using Excel’s present value function.8 Across the top of the diagram are each year’s forecasted cash flows computed in Figure 8.4. The arrows point to the present value of each cash flow—discounted at 20 percent—on the day that the required investment is made at the beginning of Year-1.
Figure 8.6 NPV & IRR: discount rate = 20%
The $220,500 cash flow anticipated by the end of Year-1—discounted at 20 percent—has a present value at the beginning of Year-1 of $183,750. This simply means that $183,750 invested at 20 percent at the beginning of Year-1 will grow to $220,500 by the end of Year-1. Likewise, the $285,320 cash flow expected by the end of Year-2—discounted at 20 percent—has a present value of $198,139 at the beginning of Year-1. In other words, $198,139 invested at 20 percent at the beginning of Year-1 will grow to $285,320 by the end of Year-2. The $245,000 cash flow anticipated in Year-3 has a present value of $141,782, meaning that $141,782 invested at 20 percent at the beginning of Year-1 will grow to $245,000 by the end of Year-3. Finally, the $260,535 cash flow anticipated in Year-4 has a present value of $125,644, meaning that $125,644 invested at 20 percent at the beginning of Year-1 will grow to $260,535 by the end of Year-4.
Although the investment’s total projected cash flow over the 4-year period is $1,011,354, the total present value of those cash flows, as shown in Figure 8.6, is only $649,315. Said differently, if Satka desires a return of 20 percent, it should be willing to invest up to $649,315 for the required equipment. Fortunately, the cost of the investment is only $625,000—not $649,315—so the equipment’s NPV is $24,315. A positive NPV means that an investment’s actual return—referred to as its IRR—is expected to be greater than the required return used as a discount rate. Figure 8.6 conveys an IRR on this investment of 22 percent, which is 2 percent higher than the 20 percent required return that Satka used as a discount rate.9
NPV and IRR Relationships
An investment’s NPV and IRR are related to each other as follows:
- If an investment’s NPV is positive, its IRR is greater than the discount rate.
- If an investment’s NPV is zero, its IRR equals the discount rate.
- If an investment’s NPV is negative, its IRR is less than the discount rate.
These relationships are illustrated in Figure 8.7. The left column of the illustration lists the forecasted cash flows computed in Figure 8.4. The arrows point to the discounted present values of each cash flow at three different discount rates—20 percent, 22 percent, and 25 percent. It is important to realize that changing the discount rate has no effect on the cash flow amounts anticipated in each year. Moreover, changing the discount rate has no effect on Satka’ $625,000 investment cost. Thus, regardless of what discount rate is used, the investment’s IRR remains 22 percent, as shown.
Figure 8.7 NPV & IRR: comparisons across multiple discount rates
When discounted at 20 percent, its positive NPV of $24,315 shown in Figure 8.7 is exactly the same as it was in Figure 8.6. The NPV is positive because the investment’s IRR of 22 percent exceeds Satka’s 20 percent discount rate. Had Satka required a 22 percent return, the cash flows would have been discounted 22 percent, and their total present value would have exactly equaled the investment’s $625,000 cost, resulting in an NPV of zero—which is marginally acceptable. Finally, had Satka required a 25 percent return, the cash flows would have been discounted at 25 percent, and their total present value would have been only $591,160. Using a discount rate that exceeds the investment’s IRR by 2 percent would have resulted in a negative NPV of $33,840—which is unacceptable.
Nonfinancial Issues
In addition to financial concerns, all capital investments also involve nonfinancial issues that must be taken into consideration. Unlike financial concerns, nonfinancial issues are often subjective, making their effects difficult to measure.
Nonfinancial issues often involve environmental, ethical, legal, socioeconomic, race, gender, and morale-related considerations. Satka’s decision of whether to invest in machinery so that an idle production facility can be used to produce components for military weapons encompasses several unique nonfinancial issues. These issues include potential security threats, political repercussions, liability exposure, reputation perceptions, and patriotic responsibility.
Summary
This chapter examined the basic concepts and practices involving the capital budgeting process. Managers use capital budgets to evaluate and prioritize large, and sometimes very risky, capital investment opportunities.
The primary focus of the capital budgeting process is on the incremental effects of an investment opportunity—the most critical elements of which involve forecasting its incremental cash flows and establishing the minimum return required to compensate a company for the investment’s inherent risks.
Time-value-of-money concepts, and tradeoffs between risk and return, play a key role in determining a capital investment’s present value. An investment’s present value is a measure of its financial desirability. Present values are a function of the amount of cash a capital investment is expected to generate, how quickly the cash will be generated, and likelihood that the investment’s cash benefits will actually materialize. Generally speaking, investments with a potential to generate large amounts of cash flow, in short amounts of time, with relatively low risk, have higher present values than riskier investments that take more time to generate less cash flow.
All three capital budgeting measures illustrated in this chapter—the payback period, NPV, and IRR—are widely used to evaluate capital investment decisions. Of these measures, NPV and IRR take into consideration the time-value of money. When an investment’s IRR exceeds the discount rate used to compensate a company for risk, the investment’s NPV will be positive, and therefore financially desirable. Conversely, if an investment’s IRR is less than the discount rate used to compensate a company for risk, the investment’s NPV will be negative, and therefore financially undesirable.
Finally, it is important to bear in mind that nonfinancial issues sometimes make financially desirable investments unacceptable. Likewise, they also can make financially undesirable investments a necessity.
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1Working capital refers to the composition of a company’s current assets and current liabilities. Capital investments often impact a company’s working capital position by causing significant changes in its accounts receivable, inventory, trade payables, and income tax accruals.
2The annual rates of return referred to in this simple illustration are compound rates, and the figures provided to not include income tax consequence.
3MACRS—Modified Accelerated Cost Recovery System—is a depreciation method allowed only for federal income tax purposes. Accordingly, the use of MACRS is not permitted in the financial statements that corporations file with the SEC. Nevertheless, MACRS is frequently used for capital budgeting purposes because it directly impacts a company’s income tax payments. As such, MACRS depreciation results in a more accurate estimate of an investment’s after-tax incremental cash flow than depreciation methods used in the financial reports issued to external investors and creditors.
4The time-value of money makes the immediate tax savings provided by MACRS depreciation extremely attractive. The more quickly a company is able to deduct the cost of a capital investment for tax purposes, the more desirable the resulting tax savings become.
5Recall from Chapter 5 that depreciation expense is added back in determining net cash flow because, unlike most other expenses, depreciation reduces net income without reducing cash.
6When unforeseen negative circumstances occur prior to the recovery of an investment’s cost, the likelihood that the cost will never be recovered can pose a significant threat.
7Even when the perceived risk of a potential investment is very low, the discount rate used to compute the discounted present value of its future cash flows must at least equal the company’s weighted average cost of capital (WACC). A company’s WACC is a function of the cost of its debt financing and equity financing, and the relative reliance it places upon each financing method. Computing a company’s WACC is beyond the scope of this book. In short, if an investment’s rate of return is not high enough to offset the cost of financing it, the investment will not be profitable, nor will it increase the net financial value of the company.
8Excel’s present value function is extremely user friendly and is by far the most efficient manner in which to determine the present value of an investment’s future cash flows. The amounts shown are based on a discount rate of 20 percent compounded annually. Alternatives to Excel include financial calculators, present value tables, and the use of present value formulas.
9The 22 percent IRR figure was computed effortlessly using Excel ’s internal rate of return function.