capital budgeting decision with 3 methods

7/29/2019 Capital Budgeting Decision With 3 Methods

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Capital Budgeting Decision with 3 MethodsHome Capital Budgeting Capital Budgeting Decision with 3 Methods

ByPutra | No Comments | Putra is a CPA, formerly a controller for a corporation in Costa Mesa, CA

Last updated: Friday, December 11, 2009

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Capital Budgeting Failure on New ...

Some observers of capital budgeting practices have cited examples of how capitalbudgeting techniques have not been properly utilized [Note: One of the First is found inRobert H. Hayes and David Garvin, Managing As If Tomorrow Mattered, HarvardBusiness

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Depreciation Methods [IAS 16] Comprehensive Cash Transfer Controls

Capital budgeting relates to

planning for the best selection and financing of long-term investment proposals. Capital

budgeting decisions are not equally essential to all companies. The relative importance of

this function varies with company size, the nature of the industry, and the growth rate of

the firm. As a business expands, problems regarding long-range investment proposals

become more important. Strategic capital budgetingdecisions can turn the tide for a

company. The types of scarce resources that may be committed to a project include cash,

time of key personnel, machine hours, and floor space in a factory. When estimating costs

for a proposed project, the allocation of the companys scarce resources must be converted

in terms of money.

There are various capital budgeting methods: including accounting rate of return,

payback, discounted payback, net present value, profitability index, and internal rate of

return. However, in this post I am going to focus to demonstrate the first three methods:

accounting rate of return [ARR], payback, and discounted payback. Before that, I am

going to overview the fundamental of the budgeting decision a little bit .

Capital Budgeting Decision Fundamental

The two broad categories of capital budgeting decisions are screening decisions and

preference decisions.

Screening decisions relate to whether a proposed project satisfies some currentacceptance standard. For instance, a company may have a policy of accepting costreduction projects only if they provide a return of, say, 15 percent.
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Preference decisions apply to selecting from competing courses of action. For example,a company may be looking at four different manufacturing machines to replace anexisting one. The selection of the best machine is referred to as a preference decision.

The basic types of investment decisions involve selections between proposed projects and

replacement decisions. Selection requires judgments concerning future events of which one

has no direct knowledge. One has to consider timing and risk. The task is to minimize chancesof being wrong. To help deal with uncertainty, one may use the risk-return trade-off method.Discounted cash flow methods are more realistic than methods that do not take into account thetime value of money in appraising investments. Consideration of the time value of moneybecomes more essential in inflationary periods.

Planning for capital expenditures requires one to determine the optimal proposal, the

number of dollars to be spent, and the amount of time required for completion . An

appraisal is needed of current programs, evaluating new proposals, and coordinating interrelatedproposals within the company. In planning a project, consideration should be given to time, cost,and quality, which all interreact. For control, a comparison should be made between budgetedcost and time compared to actual cost and time.

Capital budgeting decisions must conform to the cash position, financing strategy, and

growth rate:

Will the project provide a return exceeding the long-range expected return of the business?

Projects must be tied into the companys long-range planning, taking into account

corporate strengths and weaknesses. The objectives of the business and the degree to whichthey depend on economic variables (e.g., interest rate, inflation), production (e.g., technologicalchanges), and market factors must be established. Also, the capital budget may have to beadjusted after considering financial, economic, and political concerns. But consideration shouldbe given to sunk and fixed costs that are difficult to revise once the initial decision is made.

Recommendation

Use cost/benefit analysis to answer the following two crucial questions:

Is there excessive effort for the proposal?; Can it be performed internally, or must it be done externally (e.g., make or buy)? Is there

a more efficient means and less costly way of accomplishing the end result?
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Further, problem areas must be identified. An example is when long-term borrowed funds areused to finance a project where sufficient cash inflows will not be able to meet debt at maturity.

Suggestion

Measure cash flows of a project, using different possible assumed variations (e.g., changein selling price of a new product). By modifying the assumptions and appraising theresults, one can see the sensitivity of cash flows to applicable variables. An advantage isthe appraisal of risk in proposals based on varying assumptions. An increase in riskshould result in a higher return rate.

Taxes have to be considered in making capital budgeting decisions because a project thatlooks good on a before-tax basis may not be acceptable on an after-tax basis. Taxes havean effect on the amount and timing of cash flows.

What-if questions are often the most crucial and difficult with regard to the capital

expenditure budget, and informed estimates are needed for the major assumptions.Spreadsheets can be used to analyze the cash flow implications of acquiring fixed assets. Once an investment proposal is approved, there has to be an implementation of controls

over expenditures and a reporting system regarding the projects status. Expendituresshould be traced to the project and controls in place, ensuring the expenditures are inconformity with the approved investment proposal. Continuous monitoring will showhow well the project is doing, relative to the original plan.

Below is a typical project application form example:
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The next presents an advice of project change form:


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A capital expenditure appropriation request form shown below:


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Factors to Consider in Determining Capital Expenditures

Rate of return Budget ceiling Probability of success Competition Tax rate Dollar amounts Time value of money Risk Liquidity Long-term business strategy Forecasting errors


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Types of Capital Budgeting Decisions to Be Made Cost reduction program Undertaking an advertising campaign Replacement of assets Obtaining new facilities or expanding existing ones

Merger analysis New and existing product evaluation No profit investments (e.g., health and safety)

Accounting (Simple) Rate of Return

Accounting rate of return (ARR) measures profitability from the conventional accounting

standpoint by comparing the required investment (sometimes average investment) tofuture annual earnings.

Rule of thumb: Select the proposal with the highest ARR.

Case Example

Initial Investment = $8,000Life = 15 years

Cash inflows per year = $1,300

Calculation:

Depreciation = [Cost - Salvage Value]/Life = $8,000/15 = $533

ARR= [cash Inflows per year - Depreciation]/Initial Investment= [$1,300 - $533]/$8,000 = $767/$8,000 = 9.6%

If you use average investment, ARR is:ARR = $767/[$8,000/2] = $767/$4,000 = 19.2%

Note: When average investment is used, rather than the initial investment, accounting rate ofreturn is doubled.

Advantages and Disadvantages of ARR
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Advantages of ARR:

Easy to comprehend and calculate Considers profitability Numbers relate to financial statement presentation

Considers full useful life

Disadvantages of ARR:

Ignores time value of money Uses income data rather than cash flow data

Note: In an automated environment, the cost of the investment would include engineering,software development, and implementation.

Payback Period Methods

Payback is the number of years it takes to recover an initial investment. Payback assists in

evaluating a projects risk and liquidity, faster rate of return, and earlier recoupment of

funds. A benefit of payback is that it permits companies that have a cash problem to evaluate theturnover of scarce resources in order to recover, earlier, those funds invested. In addition, there islikely to be less possibility of loss from changes in economic conditions, obsolescence, and otherunavoidable risks when the commitment is short term.

Supporters of the payback period point to its use where preliminary screening is more

essential than precise figures, in situations where a poor credit position is a major factor,

and when investment funds are exceptionally scarce. Some believe that payback should beused in unstable, uncertain industries subject to rapid technological change because the future isso unpredictable that there is no point in guessing what cash flows will be more than two yearsfrom now.

A company may establish a limit on the payback period beyond which an investment will

not be made. Another business may use payback to choose one of several investments, selectingthe one with the shortest payback period.

Advantages and Disadvantages of Payback Method

Advantages of Payback:

Easy to use and understand Effectively handles investment risk


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Good approach when a weak cash-and-credit position influences theselection of a proposal Can be used as a supplement to other more sophisticated techniques, sinceit does indicate risk

Disadvantages of Payback:

Ignores the time value of money Does not consider cash flows received after the payback period Does not measure profitability Does not indicate how long the maximum payback period should be Penalizes projects that result in small cash flows in their early years andheavy cash flows in their later years

Warning: Do not select a proposal simply because the payback method indicates acceptance.One still has to use the discounting methods, such as present value and internal rate of return.

Case Example

You are considering a new product. It will initially cost $250,000. Expected cash inflows are

$80,000 for the next five years. You want your money back in four years.

Payback period = Initial Investment / Annual Cash Inflow = $250,000/$80,000 = 3.125

Decision: Because the payback period (3.125) is less than the cutoff payback period (4), youshould accept the proposal.

Case Example

You invest $40,000 and receive these cash inflows:

Year 1 = $15,000 Year 2 = $20,000

Year 3 = $28,000

Payback Period = $40,000

Year1 Year2 Year3 = 2.18

[$15,000 + $20,000] + [$5,000/$28,000]2 Year + 0.18


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Decision: If there are unequal cash inflows each year, to determine the payback period, just addup the annual cash inflows to come up with the amount of the cash outlay. The answer is howlong it takes to recover the investment.

Payback Reciprocal

Payback reciprocal is the reciprocal of the payback time. This often gives a quick, accurateestimate of the internal rate of return (IRR) on an investment when the project life is more thantwice the payback period and the cash inflows are uniform every period.

Case Example

ABC Company is contemplating three projects, each of which would require an initialinvestment of $10,000, and each of which is expected to generate a cash inflow of $2,000 peryear. The payback period is five years ($10,000/$2,000) and the payback reciprocal is 1/5, or 20percent.

The table of the present value of an annuity of $1 shows that the factor of 5.00 applies to

these useful lives and internal rates of return:

Useful Life IRR

10 years 15%15 1820 19

Decision: The payback reciprocal is 20 percent as compared with the IRR of 18 percent when thelife is 15 years, and 20 percent as compared with the IRR of 19 percent when the life is 20 years.This shows that the payback reciprocal gives a reasonable approximation of the IRR if the usefullife of the project is at least twice the payback period.

Discounted Payback Period

Before looking at discounted cash flow methods, it should be pointed out that there is less

reliability with discounted cash flow analysis where there is future uncertainty, the

environment is changing, and cash flows themselves are hard to predict. Take into account


14/14

the time value of money by using the discounted payback method. The payback period will belonger using the discounted method because money is worth less over time.

How to Do It: Discounted payback is computed by adding the present value of each years cashinflows until they equal the investment.

Case Example

Assume the same facts as in the preceding case example and a cost of capital of 10 percent .

Discount Payback = Initial Cash Outlay / Discounted Annual Cash Inflows

$40,000 / Year1 Year2 Year3

$15,000 + $20,000 + $28,000x 0.9091* x 0.8264 x 0.7513$13,637 + $16,528 + $21,036$30,165 + $9,835/$21,0362 years + 0.47 = 2.47 years

*Present value of $1 from AI.3 = pv 1 F

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