There are several techniques for capital budgeting analysis:
- payback period
- net present value analysis
- internal rate of return
- avoidance analysis
Payback Period
The easiest but weakest of the capital budgeting techniques is the payback period. It calculates the time for the investor to recoup his original money outlay. A payback period of 3 years means it will take three years for the cash inflow to gain back the original amount of money invested. The shorter the payback period, the better for the investor because profit will be earned at a sooner date.
The payback period is very important for companies with good liquidity. Being liquid means having cash, or it will be easy to turn assets into cash. These companies cannot afford to have the money tied to an investment for a long period before any profits are earned. Their main goal is to recover the capital outlay at the quickest time possible. Hence payback period is essential. Payback period calculations are also very easy, especially when cash flow forecasts have already been established.
Example:
Consider two potential projects' cash flows and use payback period to choose the better option:
PROJECT 1 (Cashflows in $)
- Year 0: -1,000,000
- Year 1: 350,000
- Year 2: 350,000
- Year 3: 350,000
- Year 4: 350,000
- Year 5: 350,000
PROJECT 2 (Cashflows in $)
- Year 0: -1,000,000
- Year 1: 250,000
- Year 2: 250,000
- Year 3: 250,000
- Year 4: 250,000
- Year 5: 10,000,000
Solution:
To use the payback period technique, add the cashflows until the initial investment amount is reached:
For project 1, the initial money outlay of $1,000,000 is recouped by year 3.
For project 2, the initial money outlay of $1,000,000 is recouped by year 4.
Based on the payback period alone, project 1 is a better investment because it has an earlier time of recovering the initial investment.
In this example, the cons of using a payback period for analyzing potential projects can be pointed out:
- The payback period does not account for the time value of money. The money earned in year three does not have the same value as the money earned in any other year due to inflation or deflation.
- Payback period also does not consider the cash flow that happens after the money initially invested has been recovered. Project 2 has bigger returns after the payback period than the previous example, but this was not considered.
Thus, the payback period is not a good technique for capital budgeting decisions because it does not use the time value of money and future cash flow performance. Still, it may be considered the best one if the company has liquidity problems and needs to recoup investment money soon.
Net Present Value Analysis
The net present value approach or method is the most accurate in the correct valuation of cash flows from year to year. To make this happen, the after-tax cash flows are discounted by the average cost of capital. Discounted means an interest rate is factored into the equation to reflect the adjustment of money regarding inflation, thus giving real value to the cash flows.
Using the same cash flows in the previous section and assuming a discount rate of 5%, the net present value determination is as follows:
Net Present Value (NPV) {eq}=\sum_{t=1}^{n}\frac{R_{t}}{(1+i)^{t}}-R_{0} {/eq}
where
{eq}R_{t} {/eq} = net cash flow during a single period
{eq}i {/eq} = discount rate of return for a period ( decimal format )
{eq}t {/eq} = number of periods
Using this formula to calculate the NPV of the two projects, we have:
PROJECT 1:
{eq}NPV=\sum_{t=1}^{n}\frac{R_{t}}{(1+i)^{t}}-R_{0}=\frac{350,000}{(1.05)^{1}}+\frac{350,000}{(1.05)^{2}}+\frac{350,000}{(1.05)^{3}}+\frac{350,000}{(1.05)^{4}}+\frac{350,000}{(1.05)^{5}} {/eq} -1,000,000 = $515,316.83
PROJECT 2:
{eq}NPV=\sum_{t=1}^{n}\frac{R_{t}}{(1+i)^{t}}-R_{0}=\frac{250,000}{(1.05)^{1}}+\frac{250,000}{(1.05)^{2}}+\frac{250,000}{(1.05)^{3}}+\frac{250,000}{(1.05)^{4}}+\frac{10,000,000}{(1.05)^{5}} {/eq} -1,000,000 = $7,721,748.63
Both projects gave a positive net present value, which is good. Comparing both projects, the second project will bring more money to the company, so it is the better option if the company only has $1,000,000 to invest.
The NPV approach is very useful and directly shows profitability to the company. It takes into consideration the time value of money and gives real values. A simple rule is easy to follow: projects giving positive NPV are accepted, and projects with negative NPV are rejected.
Critics of this approach say that this method is easy to manipulate by overstating future cash flows and using discount rates to guarantee a positive NPV to secure the project's approval. This method is also known as the discount cash flow analysis.
Internal Rate of Return
The third method or technique for capital budgeting decisions is the internal rate of return (IRR). This discount rate will result in a net present value equal to zero. IRR is the rate at which the initial outlay is similar to the present value of the future cash flows. Once the IRR is determined, it is compared to the company's hurdle rate to see if the project will produce a higher return percentage than its percentage of capital cost. If the result is a lower rate, the project or investment will be rejected.
That is,
- If IRR > Cost of Capital: Project is acceptable
- If IRR < Cost of Capital: Project is not acceptable
The formula for IRR is given as follows:
{eq}\sum_{t=1}^{n}\frac{R_{t}}{(1+IRR)^{t}}=R_{0} {/eq}
where
{eq}R_{t} {/eq} = net cash flow during a single period
{eq}IRR {/eq} = the internal rate of return
{eq}t {/eq} = number of time periods
{eq}R_{0} {/eq} = amount of initial outlay
IRR calculation is done through an excel spreadsheet, a financial calculator or software, or a trial and where different discount rates are tried and substituted in the formula until the NPV equals zero.
Avoidance Analysis
The last method for capital budgeting is called avoidance analysis, commonly known as cost avoidance analysis. In this method, increased maintenance is compared to the replacement of equipment. It hopes to reduce investments in fixed assets by prolonging the life of current equipment and machinery via maintenance programs.
An example of this method is a detailed cost and savings analysis of maintenance vs. replacement decisions. A more frequent and planned maintenance program and its associated costs will be compared to the costs associated with replacing old equipment. If savings can be realized through better maintenance, this. is will be adopted instead of spending money on purchasing new equipment.
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