## Capital Budgeting

Category : Articles

One of the most important decisions that must be taken when selecting from a range of projects is which method(s) of Capital Budgeting a company will opt for in order to arrive at the final proposed solution. ???Investment decisions must be consistent with the objectives of the particular business. For a private sector business, maximising the wealth of the owners (shareholders) is usually assumed to be the key financial objective.??? (Atrill and McLaney, 2009, p. 259) As a company exists primarily to increase the wealth of the stakeholders it should only invest capital to implement a project when the outcome will result in benefits that exceed the cost of the investment. Appraisals need to be carried out in order to select the project which provides the best return on that investment. Capital Budgeting is the process of appraising these projects in order to select the project most suited to the company?s strategy. The purpose of this report is to discuss four methods of appraisal (Payback Period, Accounting Rate of Return, Net Present Value and Internal Rate of Return). A case study describes each of these appraisal processes when applied to the requirement to purchase one printing press, to be selected from two qualifying contenders. This is achieved through an in-depth appraisal analysis coupled with a review of sensitivity analysis, in turn followed by an assessment of installation risks that could adversely affect the appraisal process.

???Budgeting and cost management is the estimating of costs and the setting of an agreed budget, and the management of actual and forecast costs against the budget.??? The Association for Project Management Book of Knowledge (APMBoK, 2006)

Companies initiate projects that are in line with the defined strategy of their organisation and which are intended to add value to the organisation. Any organisation that embarks on such a project (or portfolio of projects) must scrutinise each potential project to ensure that the cost of completing the project will ultimately be beneficial to the organisation when measured against the ???do nothing? option. Corporate strategy is geared toward the goal of maximizing the value of the organisation, consequently managers must implement structured ways to handle capital budgeting in line with their organisations financial

structures.

Organisations invest in both long term and short term opportunities. Capital budget investments should be thought of as being a considerable expense in the development of an asset in the long term. Assets may be physical items such as plant equipment, infrastructure and property or may be more ethereal such as intellectual property, patents, design, research and development, etc. Regardless of their nature these projects will usually be long lived and extensive in scope.

???The need for relevant information and analysis of capital budgeting alternatives has inspired the evolution of a series of models to assist firms in making the “best” allocation of resources.??? (Cooper et al, 2001)

Due to the nature of these investments, due care must be taken in selecting the appropriate projects for capital investment. They have a huge impact on the organisations future and decisions cannot be taken lightly.

Capital investment fits into the corporate financial scheme as indicated by Figure 1.

Figure 1 – Financial Structure and Capital Budgeting

Strategic Goals Maximising Organisational Value

Investment Options

Long Term

Short Term

Capital Budgeting Source: Author

Page 2

The objective of this report is to assess the implications of commercial issues within the project management environment. In particular to evaluate financial issues, cost control principles, cost management and capital budgeting techniques associated with the management of projects in various stages of the project life cycle. The various techniques addressed in this report are set out as follows:

Payback Period

Accounting Rate of Return (ARR)

Net Present Value (NPV)

Internal Rate of Return (IRR)

This report will be based upon a hypothetical case study using researched data. This project data will be used to describe an understanding of the investment appraisal techniques set out in the objectives.

The individual techniques will be illustrated through a simulated appraisal process.

The payback method is the simplest of the investment appraisal methods. As the name implies it is used to define the period of time required to recoup the investment capital from the future cash flow returned by the project.

It is observable that the shorter the payback period, the more lucrative the project will be perceived. Organisations will have standard payback periods for their projects and any that have a payback period in excess of the organisation?s limits will be rejected. Another incentive to use the payback method is that a project with short payback periods allows the organisation to put the investment capital back to work in other projects.

Given the choice between several projects management may choose to implement a project based purely on the payback period method as it is easy to use and understand; it also implies a lower risk factor as faster repayment of capital is achieved. The calculation for the payback method is illustrated in Figure 2.

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Figure 2 – Payback Method

Costs of Project

Investment

Annual Cash Flow

Source: Author

As this method focuses solely on when the investment will be returned it is generally only used as a basic tool. Using this method does not explicitly allow for any variance for the time value of money; although as the method preference is for the shortest payback period the time value of money may be implicitly considered through the timing of cash flows as described by Gitman (2008, p 343). Neither does it allow for any income past the payback date to be forecast or calculated; the whole of the project lifecycle is not included in the appraisal, merely the time required to recoup the investment.

This method uses the profit (rather than cash flow) generated by a project with regard to the investment required to attain that profit and is expressed as a percentage. The basic calculation is shown in Figure 3. This method does allow for the whole project lifecycle to be considered, whereas the payback method does not, however it similarly does not allow for variance in the time value of money.

Figure 3 – Accounting Rate of Return

Average Annual Operating Profit X 100% Average Investment to earn that Profit

Source: Author, Atrill and McLaney (2009, p.261)

An advantage of ARR is that a depreciation factor can be added to the equation to provide a better overall view of the appraisal; Figure 4 illustrates.

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Figure 4 – ARR with Depreciation

Average Operating Profit

?

Depreciation X 100%

Average Investment to earn that Profit

Source: Author

These formulae are used to show the basic form of ARR; however there are several variations of the ARR formula so when comparing projects within an organisation it is vital that the ARR is calculated in a uniform manner. The results of the appraisal will again assist in the selection of projects based on return on investment, but due to the nature of the appraisal substantial profits in the future (project year 5 for example) are given the same weighting as substantial profits occurring early in the project (e.g.: year 1). Clearly the project with larger profits in year one would be favourable, but ARR will not distinguish between the two.

The previous appraisal techniques both failed to explicitly take into account the time value of money. NPV addresses this failing by incorporating the time value of money which may lead to different results when the same project data is used in the NPV formula as against the payback or ARR methods. NPV has become a popular method of investment appraisal and uses the assumption that if you have one dollar today it will be worth more than that one dollar in a years? time.

Consequently, if an organisation is going to invest capital in undertaking a project now, then future cash flows should be judged against the value of the investment when it is actually made (i.e.: today?s value). If these future cash outflows and inflows produce a positive value, then the project should be recommended (see Figure 5). Where multiple projects produce a positive NPV, but only one can be initiated, perhaps due to capital rationing, the project with the higher NPV should be selected.

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Figure 5 – NPV ???Go ??“ No Go?

NPV Result ? 0 Project Selected

NPV Result < 0 Project Rejected Source: Author Although the NPV formula (see Figure 6) is a sophisticated budgeting technique it has been incorporated into various spreadsheet packages making its use relatively easy to implement. Figure 6 - Net Present Value Formula Source: Author, RGU (2008) Table 1 - NPV Formula Key Net Present Value formula values: FV Future Value of Cash Flows II Initial Investment k Discount Rate Source: Author The main issue with using NPV is with ensuring the accuracy of the forecast cash flows and benefits, as with all formulae the result is only as good as the data input. A secondary issue is the possible manipulation of results by choosing different values of discount rates, as discussed previously an organisation must ensure that the appraisal method is employed uniformly. There have been discussions on several online forums regarding the accuracy of the spreadsheet NPV function due to the assumption that the values are all payable at ???end of year? and that the initial investment is considered as part of the cash flow series. This can be readily overcome by omitting the initial payment from the function values and adding it to the overall result (Microsoft, 2011). IRR is step beyond NPV and is used to arrive at the interest (or discount) rate at which the NPV is equal to zero. Whilst being a complicated appraisal technique (Figure 7 illustrates) Page 6 IRR is also found in most popular spreadsheet packages and as such can be easily implemented by the desktop computer user. Figure 7 - Internal Rate of Return Formula Source: Author, RGU (2008) Table 2 - IRR Formula Key Internal Rate of Return formula values: FV Future Value of Cash Flows II Initial Investment Source: Author IRR focuses on the percentage return generated by a project rather than its net present value. The interest rate given where the calculation returns a zero net present value is the internal rate of return (see Figure 8), the higher the IRR value the better. The IRR should be higher than the cost of capital if a project is to be selected. IRR works well where the cash flows are predictable and remain positive, however when there are multiples instances of both negative and positive cash flows, perhaps due to a project change request being implemented, then IRR can produce varying values which may appear misleading. Figure 8 - Internal Rate of Return Illustrated 50 Net Present Value 30 10 -10 -30 -50 Internal Rate of Return Interest Rate Source: Author Where IRR does not work well is with differences of scale, i.e.: Which is better; a large return on a small investment or a small return on a large investment IRR is unable to Page 7 determine the difference and simply reports the rate at which the NPV is zero. Other problems arise with IRR such as discount rates changing over the life of the project, perhaps due to a long project term. IRR also struggles when appraising projects with unequal lifecycles. The Technical Studies Institute of a major Middle East defence establishment has to replace the printing press used to publish the study material for cadet training. A choice has to be made between two identified options, ???Press A? and ???Press B?. Both printing presses satisfy the requirements and have passed a ???feasibility study??? (Stevens, 2002); as such an appraisal is required to decide which of the two should be selected. Due to capital rationing only one press can be purchased. For the purpose of this exercise the cost of capital has been set at 12% and the organisation depreciates any fixed asset on a straight line basis. The exercise will use the cost profile data presented in Tables 3 & 4 with the four investment appraisal techniques already described in this report. Table 3 - Cost Profile, Printing Press A ($) Model Purchase Price 1 2 3 4 5 6 7 8 9 10 11 12 Scrap $ Press A 110,000 Net Cash p/a 22,000 22,000 22,000 22,000 26,000 26,000 26,000 26,000 20,000 20,000 20,000 20,000 6,000 Depreciation p/a 8,666 8,666 8,666 8,666 8,666 8,666 8,666 8,666 8,666 8,666 8,666 8,666 Source: Author Page 8 Table 4 - Cost Profile, Printing Press B ($) Model Purchase Price 1 2 3 4 5 6 7 8 9 10 11 12 Scrap $ Press B 230,000 Net Cash p/a 34,500 34,500 34,500 26,750 26,750 26,750 22,500 22,500 22,500 25,000 25,000 25,000 9,000 Depreciation p/a 18,416 18,416 18,416 18,416 18,416 18,416 18,416 18,416 18,416 18,416 18,416 18,416 Source: Author Each appraisal technique will be simulated and a recommendation as to which press should be ordered according to that appraisal. Once identified, the delivery and installation of the printing press will be investigated with respect to where cost and budget can be controlled. Table 5 - Payback Period, Press A PRESS A Cost Year 1 2 3 4 5 110,000 Cash Inflow 22,000 22,000 22,000 22,000 26,000 Accumulated 22,000 44,000 66,000 88,000 114,000 Source: Author Payback Period for Press A = 5 Years. Table 6 - Payback Period, Press B PRESS B Cost Year 1 2 3 4 5 6 7 8 230,000 Cash Inflow 34,500 34,500 34,500 26,750 26,750 26,750 22,500 22,500 Accumulated 34,500 69,000 103,500 130,250 157,000 183,750 206,250 228,750 Page 9 9 22,500 251,250 Source: Author Payback Period for Press B = 9 Years. Given the above information the investment recommendation would be for Press A as the return on initial investment occurs in year 5, four years ahead of Press B. This merely states that with a much lower purchase price than the alternate choice, Press A will achieve payback sooner than Press B. It takes no account of the possibility of variance in finance costs and relies solely on the estimated cash inflow values, which may in turn be subject to weakening by future inflation rises. The forecast cash inflows must be consistently accurate in order to minimise risk from over or under estimation. The whole of the project lifecycle is not assessed as the only concern is the repayment of the initial investment. Future large profits, whilst unlikely in this scenario, would be dismissed as irrelevant. Given the values quoted in Tables 3 & 4 for initial purchase price, yearly income and depreciation the following can be determined. Table 7 - Press A, Profit and Depreciation Press A: Average profit Depreciation p/a Investment 22,667 8,667 110,000 Source: Author Using the formula for ARR as defined in Figure 4 - ARR with Depreciation, the following results are obtained (see Figure 9). Page 10 Figure 9 - ARR Value, Press A 22,667 - 8,667 X 100% = 12.73% 110,000 Source: Author Table 8 - Press B, Profit and Depreciation Press A: Average profit Depreciation p/a Investment 27,188 18,416 230,000 Source: Author Using the formula for ARR as defined in Figure 4 - ARR with Depreciation, the following results are obtained (see Figure 10). Figure 10 - ARR Value, Press B 27,188 - 18,416 X 100% = 3.81% 230,000 Source: Author This method of appraisal shows a vast difference in values (see Table 9), mainly due to the high purchase price of Press B. Table 9 - ARR Comparison of Press A and Press B ARR Press A Press B 12.73% 3.81% Source: Author In a straight forward ARR comparison the choice would be Press A, having the higher percentage Average Rate of Return. Again this appraisal does not consider the possibility Page 11 of inflation or interest rate changes, expecting the time value of money to remain constant. The NPV for both printing presses has been calculated (see Tables 10 & 11) using a discount rate of 12% and standard present value tables obtained (Atrill and McLaney, 2009, p. 522). The results are compared in Table 12. ?® Alternate calculations were then made using Microsoft Office Excel (see Figure 11) and OpenOffice.org Calc?® (see Figure 13) spreadsheets. The formulae used by these two applications are displayed for comparison (see Figures 12 & 14). Minor differences are noted in the final values for Press B which is considered to be due to internal rounding of the Present Value factors within the spreadsheet calculation. Table 10 - Calculated NPV for Press A Press A Year 0 1 2 3 4 5 6 7 8 9 10 11 12 Cash Flow -110,000 22,000 22,000 22,000 22,000 26,000 26,000 26,000 26,000 20,000 20,000 20,000 20,000 Net Present Value PV Factors 1 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 0.4039 0.3606 0.3220 0.2875 0.2567 Present Value -110,000 19,646 17,534 15,664 13,992 14,742 13,182 11,752 10,504 7,220 6,440 5,760 5,140 31,544 Source: Author Table 11 - Calculated NPV for Press B Press B Year 0 1 2 3 4 5 6 7 8 9 10 11 12 Cash Flow -230,000 34,500 34,500 34,500 26,750 26,750 26,750 22,500 22,500 22,500 25,000 25,000 25,000 PV Factors 1 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066 0.4523 0.4039 0.3606 0.3220 0.2875 0.2567 Present Value -230,000 30,809 27,497 24,564 17,013 15,167 13,562 10,170 9,090 8,123 8,050 7,200 6,425 Page 12 Net Present Value -52,372 Source: Author Table 12 - NPV Comparison of Press A and Press B NPV ($) Press A Press B 31,544 -52,372 Source: Author Figure 11 - Microsoft Office Excel NPV Screenshot ?® Source: Microsoft Office Excel , Author ?® Figure 12 - Microsoft Excel NPV Formula ?® Source: Microsoft Office Excel , Author ?® Figure 13 - OpenOffice.org Calc NPV Screenshot ?® Page 13 Source: OpenOffice.org , Author ?® Figure 14 - OpenOffice.org Calc NPV Formula ?® Source: OpenOffice.org , Author ?® Appraisal of these values leads to the logical conclusion that under the NPV technique, Press A would be recommended, having a positive NPV of $31,544. Press B, having a negative NPV, would not be recommended. The IRR has been calculated using the spreadsheet NPV function in a trial and error process using varying discount rates to obtain the rate which returns a NPV ? 0 (Table 13). Table 13 - Calculated IRR, Press A and Press B Internal Rate of Return Press A 18 % Press B 6% Source: Author This was then compared to the values returned by the IRR function of both Microsoft Office Excel ?® (see Figure 15) and OpenOffice.org Calc?® (see Figure 16) and found to be consistent. Page 14 Figure 15 - Microsoft Excel IRR Calculation Screenshot ?® Source: Microsoft Office Excel , Author ?® Figure 16 - OpenOffice.org Calc IRR Calculation Screenshot ?® Source: OpenOffice.org , Author ?® As a result of the IRR analysis the selected choice would be Press A, achieving a higher internal rate of return which is also above the discount rate of the investment. Press B could not be selected, the IRR is less than that of the discount rate. The IRR method has produced stable results for this appraisal but it is entirely possible to have calculations return multiple values of IRR, for instance when there are multiple Page 15 positive and negative cash flows, which may prove disconcerting for a project office trying to decide between multiple projects. Whilst the above appraisals all recommend Press A in this instance; if one appraisal technique identifies one particular piece of equipment, it should not be taken as a given that the other methods would identify the same equipment in every scenario. Sensitivity analysis: ???. . . involves an examination of the key input values affecting the project to see how changes in each input might influence the viability of the project.??? (Atrill and McLaney, 2009) Sensitivity analysis tests each aspect of a project?s factors, in isolation, to see when variation of that value causes the NPV to be equal to or less than zero. This variation is essentially the safety margin allowable for that factor. Subjecting all the factors that pose a risk to the project to sensitivity analysis will provide a very good overall view of the ability of the project to withstand change arising from uncertainties in long term projects (inflation, interest rate fluctuation, etc.). The delivery and installation of the printing press must be accomplished in a tight time schedule; accordingly several risks have been identified in this process. The primary issue is that the printing press has to be sourced from an overseas vendor. This raises multiple problems such as export licenses (from vendor country) and import problems (customs clearance, etc) all of which could affect project timescales. A comprehensive Work Breakdown Structure (WBS) has been developed for the project, covering disposal of the old printing press, civil works required for the replacement and final installation and commissioning of the newly purchased press. The project is time bound; printed material must be ready for the new intake of cadets attending the institute. As with all time bound projects there are risks involved in assuring that the project does not overrun. Milestones have been agreed with the supplier and Page 16 stage payments will be made accordingly upon successful achievement of the milestone criteria. Performance measurement techniques are to be employed in order to assure the project completes on time. Despite best efforts it is possible that delays will occur due to unforeseen risk, inadequate estimation of required resources or the need to perform additional work. A robust change management process will ensure that where additional costs are incurred they will be charged back to the appropriate responsible department. Any variances arising from such change orders will be primarily assessed for their impact on the project schedule and budget. Earned Value Analysis (EVA) as a process evaluates schedule and cost performance for the project. According to Levine (2005) ???EVA provides an early warning system for schedule and cost overruns??? and as such will alert the project manager to the fact that an investigation is required into the variance. The objective of this report was to assess the implications of commercial issues within the project management environment with particular respect to capital budgeting techniques. Having considered the four methods of appraisal set out the following conclusions can be drawn. When selecting a project the Project Manager has a number of choices when deciding how to appraise competing options. With respect to Capital Budgeting the choice must be made with reference to the scale of project being considered. Large, complex projects may be best appraised using the Net Present value method; shorter less complex projects may well be suited to Average Rate of Return or even Payback Period methods, depending on the company strategy regarding capital returns. Not all appraisal methods take account of the entire project lifecycle (including future profits/losses), or indeed the time value of money. This can lead to a skewed perspective if an inappropriate method is selected for project appraisal. Due to the nature of some appraisal methods, late profits are given the same weighting as Page 17 early profits, which may be misleading. Businesses may well prefer projects that return early profits as these can be re-invested. Whichever method of appraisal is selected, care must be taken to ensure it is reliably applied in a consistent manner across the range of projects being appraised. The Project Manager must also guard against erroneous data being used when estimating future cash flow or profits. The Internal Rate of Return method is somewhat problematic as it is possible, due to cash flow scenarios, to have multiple IRR values. This could negatively impact the perception of the quality of this appraisal. Desktop computers are now more than capable of processing the complex calculations required for appraisal techniques such as Net Present Value or Internal Rate of Return. Although these methods are now integrated into spreadsheet applications as defined functions, care must be taken to ensure data is entered correctly due to assumptions made by the formula regarding when cash flows occur. Each project should be subjected to sensitivity analysis to ascertain the safety margins available for the factors involved. A robust change management process must exist in order to protect the project from variance in cost and schedule. Earned Value Analysis will be pivotal in alerting the project manager to schedule and cost overruns. Although mentioned within the context of this report, additional factors have been eliminated from the case study in order to focus on the actual appraisal methodology. These factors include projects with unequal lives, variation of interest rates and multiple positive and negative cash flows; all of which would have a real life impact upon the appraisal process. In a genuine appraisal process all of the above would have to be taken into consideration. Page 18 References. ATRILL, P., and MCLANEY, E., (2009), Management Accounting for Decision Makers, 6th Edition, Prentice Hall (Financial Times) APM, 2006, Association for Project Management Body of Knowledge, 5th edition. The Association for Project Management COOPER, W. D. et al., 2001, Capital budgeting models: theory vs. practice. Business Forum, 26 (1/2), pp15-19 GITMAN, L. J., 2008, Principles of Managerial Finance, 12th Edition, Pearson Education. LEVINE, H. A., 2005, Project Portfolio Management, Wiley. MICROSOFT.COM, 2011, NPV Function, [online] Available from http://office.microsoft.com/en-us/excel-help/npv-function-HP010342728.aspx Accessed on 10/03/2011 STEVENS, M., 2002, Project Management Pathways, GB: The Association for Project Management Limited. THE ROBERT GORDON UNIVERSITY, 2008, BS3353 Projects ??“ The Commercial Context. Topic 3: Project Economics and Forecasting. Bibliography. ACCOUNTINGSTUDY.COM, 2009, Present Value Factor Table, [online] Available from http://accountinginfo.com/study/pv/table-pv-s-01.pdf Accessed on 28/02/2011 GARRISON, S., 1999, Present Value Factors, [online] Available from http://www.studyfinance.com/common/table3.pdf Accessed on 28/02/2011 Page 19 OLYMPIA BUSINESS SCHOOL, 1999, Advanced Diploma in Accounting [Online] Available from: http://www.olympia.edu.my/student_services/materials/MgtACC2.PDF Accessed on 24/02/2011 Page 20