17 DEC 2017
The Modern Applications of Capital Budgeting
While there are many different methods of capital budgeting that firms can utilize, ranging from very simple methods such as the payback method, to more complex methods such as Net Present Value (NPV), the most popular methods of capital budgeting have largely remained unchanged for decades. Throughout this paper, the general concept of capital budgeting and a brief history of capital budgeting techniques will be covered. The bulk of this paper explains the most popular methods of capital budgeting and the approach that modern managers take while using these techniques.
What Capital Budgeting Is
Before explaining the history of capital budgeting and the modern applications of capital budgeting, a brief explanation outlining what capital budgeting is, is necessary. capital budgeting, sometimes called investment appraisal, is the set of techniques that firms use to determine what projects are worth investing in, and what projects are worth scrapping. “Capital budgeting decisions are very important for financial managers, since they determine the choice of investment projects that will affect company value” (Daunfedlt & Hartwig 1). It is arguable that capital budgeting decisions are among the most important decisions a company will make, they can make or break a company and investors will take notice. Capital budgeting is generally only utilized when companies have a choice to invest in significantly large ventures, called capital expenditures. These expenditures can be different things such as buying new machinery, building a new plant, investing in an expensive research and development project, or investing a large amount of money for long-term growth. The purpose of capital budgeting is to see what project brings the most long-term gains to a company and in turn make that company more valuable to its shareholders. There are many different methods to determine the long-term gain of a project, some of which will be discussed throughout this paper.
A Brief History
As stated in the introduction, capital budgeting has remained largely unchanged for several decades. There has not been very many new methods introduced to the capital budgeting practice, and the older methods have remained as the most used methods to this day. According to Ryan Patricia and Ryan Glenn of Colorado State University, in their paper Capital Budgeting Practices of the Fortune 1000: How Things Have Changed, IRR has widely been the most popular used capital budgeting technique in the past four decades among mangers, while academics have maintained a teaching that NPV is the superior method, this can be seen in Table 1, which depicts the most popular methods of capital budgeting among Fortune 1000 companies throughout the years 1960 and 1996.
Table 1 Preferred Method of Capital Budgeting 1960 – 1997
There could be many reasons why managers are going against the status quo of the academic world by choosing IRR over NPV for their preferred capital budgeting technique. Patricia and Glenn simply state that managers prefer IRR over NPV because a percentage is easier for managers and investors to read and understand versus a dollar amount that is given by the NPV method. Patricia and Glenn give many reasons why academics prefer NPV over IRR
Academics have long argued for the superiority of NPV over IRR for several reasons. First, NPV presents the expected change in shareholder wealth given a set of projected cash flows and a discount rate. For mutually exclusive projects, there is some dispute over the appropriate method, Second, when cash flows are reinvested at the cost of capital, Internal rate of return, on the other hand, assumes the intermediate term cash flows are reinvented at the IRR, which for any positive NPV project is higher than the cost of capital. Finally, NPV is not the sensitive multiple sign changes in cash flows. It is a method that presents the expected dollar amount that shareholder wealth would increase or decrease upon the acceptance of a project (Patricia & Glenn 356).
Although there are many reasons why NPV is superior at estimating the long-term profit of a project, managers throughout the past five decades have still chosen IRR because it takes into account the ease of interpretation that managers and investors realize when determining the profitability of a project. The dissonance between what academics recommend and what companies actually use is called the theory-practice gap, and is prevalent in many different industries.
Modern Applications: Introduction
There are many different capital budgeting methods that companies can employ today. This section of the paper will cover the three capital budgeting methods that are mentioned the most. These methods are Payback Period, Internal Rate of Return (IRR), and Net Present Value (NPV). These methods have long been the most popular among managers and academics alike. This paper will cover what each method is, how to perform each method and different modern applications of each method.
While often discouraged by academics, the payback period method of capital budgeting remains by and large one of the most popular methods of capital budgeting. Payback period is simply the time it will take a project to recover any money it used, or when a project will start turning profits after its inception. The shorter the payback period, the more appealing the project looks to managers. The formula to calculate payback period is as follows
This method is discouraged for several reasons. It is a very quick and simple way to calculate the payback period of a project, but it does not take into account several things. The biggest drawback of payback period is its failure to consider the time value of money, which is prevalent in most other popular forms of capital budgeting. Payback period also assumes that the project brings in even cash flows, when this is not the case, the payback period is effectively useless.
While the payback period may be a discouraged capital budgeting technique, the discouragement comes from the position that this will be the only capital budgeting technique used. In reality, payback period is still one of the most widely used capital budgeting techniques, but managers have caught on that this technique is most valuable when it used in conjunction with other techniques that account for all of the shortcomings of payback period.
Many managers like using the payback period for the same reason that it is discouraged in the academic world. It is quick and simple. The simplicity of this technique makes payback period very quick to calculate and the answer is very easy to understand. This is especially helpful when a manager has to present to a board, the reasons a project should be accepted. If the board has little finance experience, they are likely to understand Payback Period, as opposed to the widely accepted methods in the academic world, IRR and NPV. Modern managers also use payback period as a quick way to rule out bad projects if they have many different projects to look at. Payback period is somewhat of an initial screening method to narrow down the choices, at which point other, more expansive methods, will be employed.
Internal Rate of Return (IRR)
As stated earlier, IRR has been a very popular method for capital budgeting among manager for decades. IRR is popular for many reasons, namely it takes the time value of money into account, and the product is easily understood compared to other methods of capital budgeting. IRR is the discount rate in which the net present value of cash flows from a certain project are made to equal zero. The formula for IRR is:
Ct = The net cash inflow during the time period
Co = Initial investment cost
r = Discount rate
t = Number of time periods
Once solved, the formula will produce a percentage and the higher this percentage, the more desirable the project will look to a manager. This is incredibly useful as a percentage is easily understood. In essence, the IRR is basically the rate of growth a project will see during its use.
One complication of IRR is that this formula cannot be solved analytically, but instead must be solved using a financial calculator or computer program such as excel, as this formula is solved through trial and error. Another complication to this method is that it requires one cash outflow (initial investment) and more than one cash inflow from a project in order to be a useful capital budgeting method. Thirdly, IRR also has a tendency to make projects with a shorter duration more appealing to projects with a longer duration as projects with a shorter duration will have a higher percentage rate of return, even though the longer projects may bring in more money in the long run, but at a slower rate of return. Another issue that IRR faces is the inherent assumption the formula makes that the cash inflows from a project will be reinvested in that project as opposed to investing those inflows into another aspect of a company. Lastly, IRR can produce more than one answer for a given project when that project has abnormal cash flows, which can be confusing for managers and boards alike.
What modern managers are trending toward to solve the drawback of IRR is using a different form of IRR, which is called modified internal rate of return (MIRR). The formula for MIRR is:
FVCF(c) = Future Value of positive cash flows at cost of capital
PVCF(fc) = Present value of negative cash flows at the financing
n = Number of periods
MIRR is helpful in solving several modern managers concerns when using the IRR method, but it is still gaining headway in the world of modern capital budgeting. While a definite step up from the IRR method, MIRR still does not gain recognition by academics as being the most useful capital budgeting method.
Net Present Value (NPV)
Net present value is largely accepted by academics to be the most useful and comprehensive capital budgeting technique. NPV is so acclaimed in the academic world because it tells a company the value of all of the future dollars a project will make, but in terms of today’s dollars, giving todays project worth. In other words, the NPV formula takes the time value of money (TVM) into account. This is important because a future dollar is worth less than a dollar in hand at the present moment due to inflation.
While calculating net present value, managers are looking for projects with a positive net present value, which identifies that the project will gain. The project with the highest NPV is the most appealing project to managers. The formula for NPV is the most complicated formula in this paper and it is as follows:
Ct = Net cash inflow during period t
Co = Investment cost
r = Discount rate
t = Number of periods
NPV is one of the most popular methods for several reasons. Like IRR, calculating NPV has become exponentially easier due to financial calculators and excel spreadsheets, making this method even more appealing to managers. NPV also gives managers a ballpark number of how much money a given project will bring in. The breakdown that NPV gives for what year a project will start to bring in value is another appealing aspect to managers.
Modern managers still err on the side of caution while using NPV because the formula for NPV requires estimates of the variables used, it is essentially a bunch of educated guesses. NPV also gives a straightforward dollar amount of the worth of a project, but sometimes managers prefer the percentage result from IRR or MIRR as opposed to a dollar amount. Modern managers are running into issues when calculating NPV for a few reasons one of which pertains to the discount rate, as Illés states:
Two or three decades ago the discount rate was very often interpreted as that it comprises of the return according to the bank rate of interest or the company’s own average rate of capital profitability. Later it became unequivocal, that here the use of capital- yield expectation based on the opportunity cost interpreted for the capital and defined by the microeconomics is reasonable. Collaterally with this, the use of capital-yield expectations with differential rate based on equity capital and debt appeared in the net present value calculation (Illés 34).
The discount rate is becoming more ambiguous to estimate which means the formula is based on an even wider guess than before. Illés speaks of the profitability of a project becoming more ambiguous:
Nowadays the application of net present value formulas, in which the profitability of the project and the profitability of financing runs into one another, are getting more and more typical. It is not rare that the financing terms based on the corporate average capital structure and their financial conditions are taken further for the given projects. Relations of investment- profitability, financing-profitability and financing- expedience are amalgamated. In order to get a clear picture it would be practical to examine separately the profitability of the project and the profitability of the different versions of financing (Illés 34).
Modern managers are having a harder time deciphering where profitability comes from, whether it is the project itself or the financing options they used. Since profitability source is becoming more ambiguous, NPV is becoming less sought after by managers.
Due to the many issues that modern managers are facing while using the NPV approach, managers are starting to approach NPV in an alternative way. Since interest rates are volatile, a project may have a negative NPV today, but will yield a positive NPV when the interest rate drops below a certain percentage. According to Ross, the volatility of interest rates should make modern managers approach NPV in a new light. “Because nearly all investments involve the option to undertake them when financing alternatives are more favorable, in general, the preferred way to deal with such investment decisions is to treat them as serious options on the financing environment” (Ross 101). Ross states that major investments should be viewed not as a give or take problem, but as option pricing problems, where we calculate what the interest rates need to be in order for the investment of a project to be worthwhile. In order to calculate the optimal hurdle rate of a project Ingersoll and Ross came up with an equation in 1992. Ross explains this equation in his paper Uses, Abuses, and Alternatives to the Net-Present-Value Rule. Below is a paraphrasing of Ross’s explanation of calculating the preferred hurdle rate of a project.
r0 = Instantaneous rate at which project has 0 NPV
r0 is calculated with the following formula:
and v is calculated with the following formula:
Ross explains that the solution can be used for the cutoff hurdle rate on a T-period bond with the IRR which is calculated by:
The hurdle rate of a T-period bond is:
Ross goes on to explain that when the local expectations hypothesis is assumed the interest rate premium is 0. This hurdle rate is approximated without time being a factor with:
Essentially, the Ingersoll and Ross equation is a new take on NPV that modern managers can use to account for the volatility of interest rates. This opposes the NPV rule that states that if the NPV of a project results as a negative, the project should be denied. The equation that Ross outlines here rids managers of the assumption that interest rates are fixed and it keeps projects on the table so managers can use them when the interest rate drops below the threshold that makes the projects worthwhile investments.
While popular capital budgeting methods have largely remained unchanged throughout the past several decades, modern managers take a slightly different approach to each method in the modern world, with the exception of the payback period, which has not seen much change. Modern managers have taken IRR and made a new formula called MIRR that accounts for several of the shortcomings of the long-esteemed IRR method. The NPV method remains the most critically acclaimed capital budgeting technique in the academic world, but modern managers and past managers alike account for the shortcomings of NPV. New methods of calculating NPV can help modern managers more effectively use the NPV method while rejecting long held rules of NPV that no longer apply in the 21st century. Finally, managers old and new have also largely understood that every capital budgeting technique has its own set of disadvantages and the most advantageous way to approach the problem of capital budgeting is to use several different methods when determining what projects to accept and decline.