Capital investments are those that are considered long-term investments such as manufacturing plants, R&D, equipment, marketing campaign, etc. , and capital budgeting is “the process of identifying which of these investment projects a firm should undertake” (Smart, Megginson & Gitman, 2004, pg. 227). According to Smart, Megginson & Gitman, there are three steps in the capital budgeting process: * Identifying potential investments Analyzing the set of investment opportunities, identifying those that will create shareholder value, and perhaps prioritizing them * Implementing and Monitoring the investment projects selected This paper will focus on step two, and will discuss the strengths and weaknesses of the four most common methods that are utilized for evaluating, selecting and prioritizing projects in the corporate world. Net Present Value (NPV), Internal Rate of Return (IRR), Straight/Discounted Payback Period and Profitability Index are the four of the most come methods used during step 2 of the capital budgeting process.
Four fictional potential capital investments will be used to illustrate how the different methods can affect project selection for a portfolio.
Theme Park Capital Investments
A theme park senior executive management team had four capital projects presented during the last capital budget meeting. The projects are a $250M park expansion, $50M value resort renovation, $500M new moderate resort construction and $200M new value resort construction. All these projects have similar completion time frames and have 20 year life expectancies.
Years 1 to 5 cash flows for each project come from the pro formas, and Years 6 -20 are based on an expected 2% per increase in cash flows. The company has $750M to invest on capital projects this year, and they must decide which projects should be approved.
Net Present Value
Net Present Value is the sum of discounted future cash flows and provides the appropriate adjustments for the time value of money. In short, NPV is the reverse of compounding interest, and this process begins with the selection of a “discount rate. ” According to Smart, Megginson & Gitman, pg. 01, “A project’s discount risk must be high enough to compensate investors for the project’s risk” The discount rate can be based on the inherent risk of a project, the required rate of return on shares, cost of equity, etc. The discount rate should not be one rate for all projects with in a firm, but reflect the nature of the project. The formula for NPV is: In this calculation, CFt represents the net cash flow of the year and r is the selected discount rate. CF0 usually represents the initial outlay to get the project started, and is usually a negative cash flow.
As a rule, projects with a negative NPV are not approved, but a “hurdle” could be set such as projects with a NPV <$100M will be dismissed. The main strength of using NPV in project selection is that risk of each project analyzed can be accounted for differently by adjusting the discount rate. This means that more risky a project, the higher the discount rate applied to the calculation. Other strengths of NPV are that it focuses on cash flow instead of accounting earnings, firms would select projects that should have a positive impact on the firm, and it evaluates the life of the project instead of just the early years.
The main weakness of using NPV is the “inability to incorporate the value of managerial flexibility. ” This means that there may be “options that the managers can exploit after an investment has been made to increase its value” (Smart, Megginson & Gitman, 2004, pg. 236).
Internal Rate of Return
Internal rate of return (IRR) is rate of return that a firm expects to earn if it selects the project and holds it for its economic life. That rate of return is the discount rate that will make the NPV equal zero. This discount rate can be determined with a financial calculator, excel or trial and error.
Once this rate is determined, it is then compared to a “hurdle rate” established by the firm. The “hurdle rate” should be set “at a level that reflects market returns on investments that are just as risky as the project under consideration” (Smart, Megginson & Gitman, 2004, pg. 238). The “hurdle rate” is the discount rate in most cases. IRR, like NPV, takes the in to account the time value of money. This means that the first year cash flows are greater in value than the second year and so on for the economic life of a project.
The second strength is that the “hurtle rate” can be based on market returns of similar projects. The last is that since it is a “rate of return”, it is more understandable to non-financial managers than NPV. There are some mathematical “quirks” of IRR that should be noted. If the cash flows alternate between negative and positive values, it is possible to have multiple IRRs. In cases with borrowing and lending, it is possible to have a positive IRR that meets the “hurtle rate”, but could have a negative NPV. Lastly, sometimes due to the nature of the cash flows, there could be no real solution.
The last two issues with IRR that deal with the scale and timing of a project’s cash flows. The scale issue can show as example of a friend promises to pay you $2 tomorrow for $1 today. This means that the IRR for this transaction is 100%, but let’s say that the amounts were $150 tomorrow for $100 today. The IRR would then be just 50%. The first deal increases your wealth by $1, but the other increases your wealth by $50. The timing issue has to do when comparing projects that have higher cash flows earlier to projects that generate higher cash flows later in their economic life.
For example, two projects have an initial outlay of $1000, but project 1 has large cash flows near the end whereas project 2 has higher cash flows earlier. This example shows that Project 1 will have a higher impact on wealth, but because the cash flows are near the end of its life, the IRR is lower. If managers just focus on the higher IRR, they could trade short term gains for long term wealth (Smart, Megginson & Gitman, 2004, pg. 244-246).
Straight/Discounted Payback Period
The payback period is the simplest of all the methods.
Period is the time it takes a project to the cumulative cash inflows to recoup the initial outlay of the investment. Firms will set a “hurtle” such as projects must have a three year payback period to be approved. The Discounted Payback period takes the method one step further by discounting the cash flows before determining the time it takes to recoup the investment. The payback method strengths are that it is simple to calculate and to understand by non-financial managers, but the weaknesses are what make this method much less desirable than NPV or IRR.
Since the payback cutoff period is arbitrary, it has little connection with increasing the stakeholders’ wealth. It is a crude way to manage risks because of the thought that the longer to recoup costs, the more risky the project, and this can lead to managers to underinvesting in long term projects that could offer higher rewards (Meredith & Mantel, 2008, pg. 47).
Profitability Index is closely related to NPV and IRR. PI is calculated by dividing the sum of the present values of the project’s cash flow less the initial cash outflow by the initial cost of the project.
Projects with a PI < 1. 0 should be rejected. The PI is useful when a firm is trying to rank investments that pass the other capital budgeting methods. Because PI is related to NPV and IRR, it shares the same strengths and weaknesses outlined previously. THEME PARK CAPITAL
Project Manager Rebuttal
When looking at the same financial analysis through the lens of a project manager, the PM may agree that projects A & B are a good choice based on financials, but may suggest that the new value resort construction (project D) should be approved as well.
This due to that there would be cost savings if both the renovation and construction projects were completed at the same time. The cost savings would be due to more efficient resource management and better prices on building materials due efficiencies of scale. The other point to make is that by building the new resort, they would increase the capacity of the guests that could stay on property to visit the new expansion.
It the end, the PM could debate that financial analysis does not take into account the synergistic positive impacts on cash flows when certain projects are placed in the portfolio (Pennypacker & Dye, 2002, pg. 187-189).
Meredith, J. R. & Mantel, S. J. (2008). Project management, a managerial approach. (7 ed.). United States of America: Wiley.
Pennypacker, J. S. & Dye, L. D. (2002). Managing multiple projects. New York, NY: Marcel Dekker, Inc.
Smart, S. B., Megginson, W. L., & Gitman, L. J. (2004). Corporate finance. Mason, Ohio: Thomson/South-Western.