The Use of Modern Capital Budgeting Techniques.

Howard Lawrence
No decision places a company in more jeopardy than those decisions involving
capital improvements. Often these investments can cost billions of dollars, and
without a suitable return the very existence of the company can be compromised.
Engineering managers play a significant role in such decisions because they are
usually closely involved in the development of specifications and the design of the
equipment or facility. Where many engineering managers fail, however, is in their
ability to understand the various techniques to evaluate the profit potential of such
investments and to understand the limitations of such techniques. This paper
examines the most common techniques of capital budgeting and describes how the
results of these techniques can mislead the engineering manager into making a poor
investment decision.
Introduction
One of the most significant (and often the largest) decision made by management is that
of capital budgeting. Today’s corporations often make decisions costing billions of
dollars for capital improvements, new manufacturing facilities and even new companies.
These decisions have the capacity to literally bankrupt a company if they are made
without a proper understanding of capital budgeting procedures. Investment decisions
are worthwhile if they create value for its owners. If a decision is made to purchase an
old manufacturing facility for $500 million dollars and upgrade if for another $500
million, how does one tell if a profit has been returned? It could be argued that if the
project returns more than the $1 billion spent than it is profitable. But that simplistic
argument ignores some very important elements such as the time value of money. More
specifically, the problem for management is, “how do you tell if it will create value – in
advance.” To answer these questions, most companies use some form of capital
budgeting technique to determine if a project will add the minimum needed value to
justify the capital outlay and the risk involved.
Budgeting Techniques
While it is not the purpose of this paper to teach capital budgeting techniques, it is
important to mention a few characteristics of the various methods. The most common
capital budgeting techniques used are net present value, internal rate of return, payback,
accrual accounting rate of return and the profitability index. The most popular of these in
the United States is net present value, internal rate of return and payback.
Net present value (NPV) is a technique that determines the present value of the inflows
and outflows and then simply takes a difference between the two. If that difference is
positive it is considered to be returning the required rate of return and is an acceptable
project. If the amount is negative it is not providing a sufficient return and would be
rejected. In the event two or more mutually exclusive projects all have positive net
present values then the project with the highest NPV is selected. The generally accepted
advantages of NPV are that it considers the time value of money and is relatively easy to
calculate. On the other hand, it is often difficult for laymen to understand the results
obtained and (most importantly) it assumes that interim payments received during the life
of the project can be invested at the discount rate used in the calculation. This is often
not a true statement and can be used to manipulate the results of the analysis.
Internal rate of return (IRR) is simply a variation of NPV in tha t it attempts to find the
discount rate that provides a NPV of zero. As stated above, the net present value is
calculated by using a predetermined discount rate. If the NPV is positive it is assumed
that the actual return is higher. If the NPV is negative, it is presumed the actual return is
lower. By continuously manipulating the discount rate it is possible to hone in on the rate
where the NPV is zero. That rate is considered to be the internal rate of return. Clearly,
one of the disadvantages of IRR is that it is more difficult to calculate since it involves an
iterative process. Furthermore, because of the often-misunderstood assumption about
interim payments being reinvested at the IRR rate it is possible to have more than one
IRR for one project. On the other hand, IRR has the advantage of having a wellunderstood
resulting number and, like NPV, it does consider time value of money.
The profitability index (PI) is another variation of NPV in that it attempts to approximate
the results obtained by the IRR without the resultant computations. NPV generally
rewards large profits because it is easier for them to generate large NPVs without have a
high IRR. The PI adjusts for this by a simple change. In NPV calculations, the present
value of the outflows is subtracted from the present value of the inflows giving the NPV.
The profitability index takes those same two numbers but instead divides the present
value of the outflows into the inflows. If the resultant number is greater than one it is an
acceptable project. As stated above, this number is more likely to provide the same
ranking of competing projects as would the IRR. The PI has the same advantages and
disadvantages as the NPV method.
The payback is simply the amount of time required for an investment to generate
sufficient cash flows to recover its initial cost. Its advantage is that it is extremely simple
to calculate and the resulting number is easily understood. For example, if a project costs
$100,000 and it will return cash flows of $50,000 per year, then the company will be paid
back in two years. The disadvantages of this method are that it does not consider the time
value of money and ignores cash flows (positive and negative) after the payback date.
Limitations of Capital Budgeting
Modern accounting and finance textbooks spend significant time discussing the
techniques of capital budgeting calculations but are woefully inadequate in terms of the
shortcomings of the various methods. Numerous misconceptions and limitations exist
and a misunderstanding of these limitations can cause incorrect decisions to be made.
Discount Rate
For those methods that do use present value techniques it is necessary to either have a
predetermined discount rate or to calculate one. This discount rate goes by many names:
- Hurdle rate – implying this is an amount you must exceed to make this a
suitable project.
- Cost of Capital – implying that this is what it cost to obtain the required
capital and that the projects return must equal or exceed this.
- Required Rate of Return – an indication that this is the minimum amount
the project can return.
The company usually sets this rate, often without a clear understanding of what it really
means. The rate is usually a minimum amount and it is then adjusted upward for risk. A
company might classify projects as A, B or C with C being the riskiest project. Projects
classified “A” might have nothing added to the discount rate while “B” projects would
have a certain amount added with an even larger amount added for the “C” projects.
Companies generally assume they are actually earning the discount rate if they achieve a
NPV of zero or greater.
Examples
To understand the misconceptions in those beliefs it is worthwhile to consider an
example. Let us assume that we have only $80,000 to invest and we desire a rate of
return of at least 15%, which must be adjusted upward for riskier projects. Suppose
further that we are presented with two possible projects. The first project will return
$30,000 per year for fo ur years and have a terminal disposal value of $10,000. It is a
very low risk project because all sales required have been contracted. It is only necessary
for us now deliver the product and, furthermore, we have great experience in the area.
An analysis of the project returns some numbers that are well within our requirements.
The payback is $80,000 divided by $30,000 or 2.67 years and the NPV at 15% is a
positive $11,368. We assume therefore, that the actual IRR is greater than 15%.
Consider now the alternative investment. We can invest the $80,000 in a rock quarry
(something we know nothing about) and at the end of the year we will have received
$500,000 from the sale of the rock. Unfortunately, when we do this, the Environmental
Protection Agency will require us to refill the pit and that will require an outlay of
$500,000 at the end of the second period. The quarry will have no value after this time.
This is an extremely risky project because we are in an area we know nothing about, we
are not sure we can sell the rock after we dig it out and yet we are certain we will have to
refill the pit. Because of our skepticism we decide we need a return of 100% on the
project.
An analysis of this project returns some very impressive numbers. The payback is
$80,000 divided by $500,000 or about 0.16 years. This is less than two months and about
one twentieth of the other project. Logically however, we know this is not accurate. The
total outflows in this project exceed the total inflows so it could be rightfully argued that
the money is never paid back. Nonetheless, the payback method totally ignores those
amounts after the payback date and so this project would be reported to have an
extremely short payback.
The NPV is also impressive. Consider the following calculations:
PV of $80,000 now $(80,000)
PV of $500,000 at 100% in one year 250,000
PV of $500,000 at 100% in two years 125,000
NPV equals a positive $ 45,000
The normal assumption would now lead us to believe this project has an actual IRR in
excess of 100%. Let’s now consider the results of the two projects to make a choice.
Traditional Project Rock Quarry
Payback = 2.67 years Payback = 0.16 years
NPV is $11,368 at a rate of return of 15% NPV is $45,000 at a rate of return of 100%
IRR is presumably greater than 15% IRR is presumably greater than 100%
These results seem to clearly indicate that the rock quarry is the preferred project, yet
intuitively it is difficult to imagine that the return on this negative cash flow project could
be greater than 100%.
To further complicate the problem, consider how the analysis would look if it were
reworked at a 15% discount.
PV of $80,000 now $(80,000)
PV of $500,000 at 15% in one year 431,500
PV of $500,000 at 15% in two years 378,050
NPV equals a negative $ (27,000)
Under this analysis, the project seems to have an IRR of less than 15%. Is it possible that
a project could have both an IRR greater than 100% and at the same time have an IRR of
less than 15%? The answer is yes, depending on the assumptions that are made.
Conclusions
Capital budgeting can be a useful tool in the analysis of large projects. However, there
are serious limitations that must be considered when evaluating the results of these
projects. These limitations can be used to manipulate the results of an otherwise
unfavorable project and make it appear to have a larger return than it actually has. While
the weaknesses in these sample projects are obvious, they can be effectively hidden in
larger projects where the descriptions and financial data can run into hundreds of pages.
Evaluators should specifically ask the following questions:
1. Are there cash outflows after the payback date and how long does it take
to recoup those cash flows?
2. How will cash inflows be reinvested throughout the life of the project and
will those reinvestments earn the same or greater amount than the discount
rate on the project?
3. Does a plot of the NPVs at different discount rates indicate more than one
internal rate of return?
When appropriate, evaluators should consider alternative evaluation techniques such as
the modified internal rate of return that does not make the same assumptions. Such
alternative techniques are described in most finance textbooks.