Capital budgeting is the process of planning for projects on assets with cash flows of a period greater than one year.
These projects can be classified as:
·Replacement decisions to maintain the business
·Existing product or market expansion
·New products and services
·Regulatory, safety and environmental
·Other, including pet projects or difficult-to-evaluate projects
Additionally, projects can be classified as mutually exclusive or independent:
Mutually exclusive projects are potential projects that are unrelated, and any combination of those projects can be accepted.
Independent projects indicate there is only one project among all possible projects that can be accepted.
The Importance of Capital Budgeting
Capital budgeting is important for many reasons:
- Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period.
- When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset.
- Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan of the company.
(To learn about the importance of budgeting on a personal level, read 6 Reasons Why You NEED A Budget and 11 Most Common Budgeting Mistakes.)
In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.
All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment.
Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1- 12% in the last 20 years, so clearly the discount rate is changing.
Without modification, IRR does not account for changing discount rates, so it's just not adequate for longer-term projects with discount rates that are expected to vary.
Another type of project for which a basic IRR calculation is ineffective is a project with a mixture of multiple positive and negative cash flows. For example, consider a project for which marketers must reinvent the style every couple of years to stay current in a fickle, trendy niche market. If the project has cash flows of -$50,000 in year one (initial capital outlay), returns of $115,000 in year two and costs of $66,000 in year three because the marketing department needed to revise the look of the project, a single IRR can't be used. Recall that IRR is the discount rate that makes a project break even. If market conditions change over the years, this project can have two or more IRRs, as seen below.
Thus, there are at least two solutions for IRR that make the equation equal to zero, so there are multiple rates of return for the project that produce multiple IRRs. The advantage to using the NPV method here is that NPV can handle multiple discount rates without any problems. Each cash flow can be discounted separately from the others.
Another situation that causes problems for users of the IRR method is when the discount rate of a project is not known. In order for the IRR to be considered a valid way to evaluate a project, it must be compared to a discount rate. If the IRR is above the discount rate, the project is feasible; if it is below, the project is considered infeasible. If a discount rate is not known, or cannot be applied to a specific project for whatever reason, the IRR is of limited value. In cases like this, the NPV method is superior. If a project's NPV is above zero, then it is considered to be financially worthwhile.
So, why is the IRR method still commonly used in capital budgeting? Its popularity is probably a direct result of its reporting simplicity. The NPV method is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value.
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