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Journal of Modern Accounting and Auditing, February 2018, Vol. 14, No. 2, 90-101 D
doi: 10.17265/1548-6583/2018.02.004
DAVID PUBLISHING
Capital Budgeting: Methods, Aspects, and Issues
E. Tylor Claggett
Salisbury University, Maryland, USA
This paper furthers the understanding of capital budgeting (CB) processes. It emphasizes the assumed disposition of
the forecast cash benefits from projects. The two reasons for CB are discussed. First, which projects are and are not
acceptable from a financial prospective? Second, of financially acceptable projects, CB methods can rank or order
projects relative to desirability. Under conditions of certainty, the paper describes and contrasts three primary
methods: pay back (PB), net present value (NPV), and internal rate of return (IRR) and three secondary methods:
profitability index (PI), terminal value (TV), and modified internal rate of return (MIRR). The presentation lists the
strengths and weaknesses of each method in order to direct attention to some of the many aspects of CB decisions
that firm managers should consider. Next, approaches for taking risk into consideration are discussed. The
discussion raises the important issues of what to do with the net cash benefits from various projects when and if
they are received. Finally, the paper provides flexible tools and example problems for teaching CB in a variety of
contexts, such as professional corporate training or academic coursework.
Keywords: company finance, corporate finance, corporate investment, finance education
Introduction
For a firm to be successful, its leaders and decision makers must allocate company resources, which are
almost always limited, in an appropriate manner. The allocation of firm resources is referred to as capital
budgeting (CB). Unfortunately, many junior and senior business school students, as well as numerous managers
and owners of businesses, do not fully understand the purposes, the concepts, and methods associated with CB.
Therefore, the intent of this paper is to provide the reader with the basic CB concepts, various ways to do CB,
the weaknesses and strengths of the selected CB methods, and some interesting CB aspects worthy of
consideration.
According to Wikipedia, CB is “the planning process used to determine whether an organization’s long
term investments such as new machinery, replacement machinery, new plants, new products, and research
1
development projects are worth the funding of cash through the firm’s capitalization structure”.
For the purposes of this paper, the term “project” means any definable effort intended to enhance the value
or viability of the business (i.e., organization’s long-term investments). It could refer to the traditional concept
of acquiring the assets to manufacture or produce products for sale, but it could also refer to an advertising
campaign, an R&D undertaking, a pollution abatement scheme or even the procurement of benefits to
employees. The definition of the “project” is left to the imagination of the reader and/or decision maker.
Acknowledgement: The author would like to thank the anonymous reviewer for his or her work to improve the original drafts of
this paper.
E. Tylor Claggett, Professor of Finance, Perdue School of Business, Salisbury University. Email: etclaggett@salisbury.edu.
1 Retrieved from https://en.wikipedia.org/wiki/Capital_budgeting.
CAPITAL BUDGETING: METHODS, ASPECTS, AND ISSUES 91
It is assumed that the list of all possible projects excludes projects rejected because of corporate policies
against illegal activities, negative environmental impacts or lines of business considered harmful to the health
and/or well-being of customers, etc. Consequently, the remaining tasks for the decision maker are to select, and
then rank, projects from the prospective of their financial attributes. The CB process is intended to first
determine the acceptable projects within the universe of otherwise possible projects and second to rank projects
deemed acceptable according to desirability. This is the purview of CB.
Capital Budgeting Boundaries
Before the CB methods featured in this paper are developed, several issues must be pointed out.
First, a project’s financial benefits are almost always in the future. Therefore, they are seldom, if ever, known
for sure. Nevertheless, the following presentation will develop six CB methods (three traditional and three
less or nontraditional) without consideration of risk. As we all know, forecasting outcomes is an inexact
science at best. Therefore, despite the best efforts of experienced and knowledgeable forecasters, projected
economic benefits exist in an environment with great possible variations. So, for now, we will assume
that net benefits are “for certain”. Later, we can relax this assumption and modify the CB methods
to accommodate various measures of risk even though most, if not all measures of risk are woefully
inadequate.
Next, the list of possible projects may not be well defined in the sense that several may not be
“independent”, one project may contain parts of another project being considered, and some may not be
“mutually exclusive”. From the Wealth Management Advisor, a project whose cash flows have no impact on
the acceptance or rejection of other projects is termed as an independent project. A set of projects from which
at most one will be accepted is termed as a set of mutually exclusive projects. In mutually exclusive projects,
2
cash flows of one project can be adversely affected by the acceptance of the other project(s). The term
“mutually exclusive” is a bit vague in that it may mean by accepting one project, other projects cannot be
accepted or there is significant overlap in the projects being considered. For example, if by accepting project
“A”, part of project “B” is inadvertently accomplished. Within the scope of this paper, it is assumed that all
projects are independent, there is no project overlap and by accepting a particular project, the potential
benefits from other projects are not affected. In the real world, these simplifying assumptions are often very
unrealistic.
Because there are many aspects to consider when making CB decisions, there are many ways to do CB
and none is perfect. Students, as well as practitioners, should understand that all CB methods have strengths
and weaknesses.
Three Traditional CB Methods
Perhaps the three most popular CB methods are payback (PB), net present value (NPV), and internal rate
of return (IRR). As previously stated, no method is perfect and all have strengths and weaknesses. After these
methods are developed, three other CB techniques are introduced as alternatives that remedy some of the more
significant restrictions associated with the NPV and IRR methods. These are: profitability index (PI), terminal
value (TV), and modified internal rate of return (MIRR).
2 Retrieved from http://www.capitalbudgetingtechniques.com/independent-and-mutually-exclusive-projects/.
92 CAPITAL BUDGETING: METHODS, ASPECTS, AND ISSUES
The PB Method
The PB method is perhaps the oldest and simplest to use CB method. To calculate the payback period, one
simply determines how long it takes for the cost of the project to be repaid by the nominal forecast net financial
benefits. The length of time it takes for this to be accomplished is the “payback period”. If this time period is
less than a predetermined acceptable payback period, the project is considered acceptable. If the project’s
payback period is greater than the predetermined acceptable payback period, the project is considered
unacceptable. The acceptable payback period is really corporate policy and it may be a poor case of “one size
fits all” for many reasons such as net financial benefits that occur after the project’s payback period are not
considered and all projects do not have the same level of risk.
The NPV Method
NPV allows the decision maker to incorporate all of the projected future financial benefits and the
principles of time value of money which are both improvements over the PB method. A project’s NPV is
calculated by subtracting the future project’s cost (in present value) from the present value of the sum of the
project’s financial benefits. A project’s cost can be spread over several years and future costs can be treated as
projected negative future financial benefits. Often the project’s projected benefits can be modeled as a uniform
finite annuity or constant growth perpetuity. If no particular format matches, the benefits can always be treated
as a “series of lump sums”. A project is considered acceptable if the calculation yields a positive value for the
NPV. Projects are ranked in order of their NPV values – the larger the project’s NPV, the more desirable the
project.
To calculate the present value of future cash amounts (regardless of whether they are benefits or costs)
requires the analyst to select the “appropriate” discount rate. Briefly, the appropriate discount rate is dependent
on many factors including, but not limited to, the risk of the project, the risk free rate, the cost of capital for the
firm, and interest rates in the greater economy.
The NPV acceptance and ranking criteria make sense when one remembers the firm manager’s role is to
first, add to firm owner wealth and second, maximize firm owner wealth. If the value of the firm can be
measured as the sum of the present values of all of the firm’s projects, then adding a positive NPV project to the
firm increases firm value. Likewise, if firm management adds the project with the largest positive NPV, he or
she is maximizing frim value.
A very important and not obvious NPV assumption involves the question of how are the project’s
benefits used after they are obtained. The assumption is they are reinvested within the firm in a way to yield
exactly the discount rate used to calculate the NPV in the first place. Of course, forecasting how the project’s
benefits will be reinvested in the future is an even more daunting task than merely forecasting the project’s
future benefits. One may ask, “What is the consequence should this reinvestment assumption be violated?”
The answer is the NPV method may be compromised to some degree. In other words, it could lose its ability
to present the best project or projects to the analyst, if this assumption is not satisfied. Said differently, if the
analyst selects project A over project B and the project benefits are not reinvested at the specific discount rate
used for the NPV calculations, maybe project B should have been selected over project A in order to maximize
firm value.
CAPITAL BUDGETING: METHODS, ASPECTS, AND ISSUES 93
The IRR Method
IRR is calculated using the same equation as the one used to calculate the NPV. The difference is the
analyst is trying to determine the discount rate that drives the NPV to zero. A discount rate that drives the NPV
to zero is, by definition, an IRR. Depending on the cash flow pattern of said project, there could be more than
3
one discount rate that drives the NPV to zero.
This leads to one of the weaknesses of the IRR method. That is, how does one interpret the existence of
more than one IRR? More about this and other IRR mathematical concerns will follow in the paper.
Like the NPV method, the IRR method allows the decision maker to incorporate all of the projected future
financial benefits and the principles of time value of money into the analysis which are both improvements over
the PB method. However, unlike the NPV method, selecting projects using the IRR method is not always
consistent with maximizing firm owner wealth. Nevertheless, a project is considered acceptable if the
calculation IRR is greater than a predetermined “hurdle rate” which, in practice, is a similar task to determining
the appropriate discount rate used in NPV calculations. Projects are ranked in order of their IRR values – in
general, the larger the project’s IRR, the more desirable the project; however, there is often more to consider
when ranking projects using their values for IRR.
To elaborate, there is a reinvestment assumption associated with the future benefits that is similar to the
reinvest assumption associated with the NPV method. With the IRR method, it is assumed the future cash
benefits can be reinvested at the calculated IRR. Since many attractive projects have relatively high calculated
IRRs, satisfying this assumption is often unrealistic. If the cash benefits are not reinvested at the calculated IRR,
the consequence is the IRR method losses its ability to present the best project or set of projects to the analyst.
Similar to the NPV method, if this assumption is violated, the analyst may select the wrong project. One could
argue that the IRR reinvestment assumption is more restrictive than that of the NPV method because it is often
unrealistic to expect the cash benefits to be reinvested at extremely high rate levels. If the costs and benefits are
properly forecasted, the IRR is the discount rate that drives the NPV to zero. But, with the NPV method, the
analyst has control over the appropriate discount rate used to calculate the various NPVs. However, the analyst
has no control over what discount rate drives a particular project’s NPV to zero. Such a discount rate could
conceivably be extremely high and too high to be a reinvestment goal. Therefore, he or she can select an
appropriate discount rate that is consistent with a reasonable expectation pertaining to reinvesting the cash
benefits.
NPV Method vs. IRR Method
In most cases, the NPV and IRR methods will provide the analyst with the same results when both are used
to rank projects. However, on some occasions, the rankings are not the same. If only two projects are being
considered, the NPV and IRR rankings may be reversed. Project characteristics that favor such outcomes are:
(1) Projects of different sizes;
(2) Cash flow pattern differences and/or different project lives (short vs. long);
(3) The use of low appropriate discount rates for NPV calculations;
(4) “Ramp up” vs. “Ramp down” projects.
3 Multiple roots are possible because Descartes’ Rule of Signs applies to the IRR equation as it is a polynomial in reciprocal. The
pattern of benefits and costs from year to year may create sign changes within the equation; thus multiple solutions (IRRs) are
possible. Retrieved from https://en.wikipedia.org/wiki/Descartes%27_rule_of_signs.
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