Capital budgeting is concerned with the process of producing, evaluating, selecting and controlling capital expenditures. In this context, capital budgeting decisions are critical. Winning projects typically produce positive cash flows for a long period of time, while failing projects do not return enough cash flow to justify the investment.
Capital budgeting methods facilitate project undertaking and ensure to a certain extent the viability of the organization. On the other hand, the methods of capital budgeting are challenged in regards to the accuracy of the estimates they produce.
This paper discusses capital budgeting methods. Focusing on the analysis of net present value (NPV), regular payback period, discounted payback period and internal rate of return (IRR), the paper identifies shortcomings on NPV and regular payback period methods. These shortcomings are the result of ignoring the time value of money, the cost of debt and equity and the importance of time in regards to better informed decision making.
Keywords: capital budgeting, net present value, payback period, project evaluation
[...] NPV is a measure of profitability, which does not take into consideration the safety margin inherent in the cash flow forecasts or the amount of capital at risk. Therefore, if a project has NPV < 0 and there is a market alternative of equal risk profile, then the project will be rejected, but this doesn't necessarily mean that the project is worthless. Undertaking a project is not a now-or-never, accept/reject decision. There are cases that NPV calculations produce a positive value, but managers cannot find any reason to justify this positive NPV. [...]
[...] The regular payback period is a commonly used capital budgeting tool in the analysis of capital projects. The method identifies the payback year in which the cumulative cash inflows exceed the initial cash outflows, i.e. the cumulative cash flow is positive. To illustrate how the regular payback period is calculated, we assume Project A and Project B with the following expected net cash flows: Expected net cash flows Year Project A Project B The equation to calculate the payback period is: Payback Period = Year before full recovery + (cumulative net cash flow / net cash flow of year of full recovery) Project A Year Project A Project B The equation to calculate the discounted payback period is: Discounted Payback Period = Year before full recovery + (cumulative discounted net cash flow / discounted net cash flow of year of full recovery) Project A cash flows Discounted payback period for project A = 2 + ( 214.88 / 225.39 ) = 2.95 years Project B cash flows ) Discounted payback period for project B = 3 + ( 360.63 / 409.81 ) = 3.88 years On this basis, project A should be undertaken, as the shorter the payback period, the better the investment. [...]
[...] Shortcomings of Capital Budgeting Methods Capital budgeting methods are easy to calculate and are widely used by financial managers. However, cash flow estimation is not always straightforward because market realities are constantly changing. When financial managers have to decide on undertaking or rejecting a project, they should take into consideration all the methods analyzed in the previous sections, and not just NPV or IRR which are the most commonly used capital budgeting methods. The reason is that, particularly, net present value and regular payback period methods are often challenged in regards to the accuracy of the estimates they produce. [...]
[...] Conclusions Capital Budgeting is an exceptionally significant feature of a firm's financial management. Managers use capital budgeting in order to decide which investments in operating assets are required and which projects need to be undertaken in order to add to the firm's value. In this context, capital budgeting decisions are critical to a firm's long-term financial health. Successful capital budgeting projects typically produce positive cash flows for a long period of time. Failing capital budgeting projects do not return enough cash flow to justify the investment. [...]
[...] Capital budgeting decisions are taken based on capital budgeting methods which Estimate the expected net cash flows, evaluate a project's riskiness, and determine the appropriate discount rate to calculate the PV of the expected cash flows. Capital Budgeting Methods Financial managers use several key methods to rank projects and to decide if they should undertake them or not. The most difficult step in project analysis is to estimate the expected cash flows that a project would generate. The main assumptions are: all projects bear the same risk; cash flows per year reflect purchase costs, investment in working capital, taxes, depreciation and salvage values; cash flows occur at the end of each year (Bierman, 1992). [...]
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