Refresher Reading

Capital Budgeting: Level I

2021 Curriculum CFA Program Level I Corporate Finance

Introduction

Capital budgeting is the process that companies use for decision making on capital projects—those projects with a life of a year or more. This is a fundamental area of knowledge for financial analysts for many reasons.

First, capital budgeting is very important for corporations. Capital projects, which make up the long-term asset portion of the balance sheet, can be so large that sound capital budgeting decisions ultimately decide the future of many corporations. Capital decisions cannot be reversed at a low cost, so mistakes are very costly. Indeed, the real capital investments of a company describe a company better than its working capital or capital structures, which are intangible and tend to be similar for many corporations.
Second, the principles of capital budgeting have been adapted for many other corporate decisions, such as investments in working capital, leasing, mergers and acquisitions, and bond refunding.
Third, the valuation principles used in capital budgeting are similar to the valuation principles used in security analysis and portfolio management. Many of the methods used by security analysts and portfolio managers are based on capital budgeting methods. Conversely, there have been innovations in security analysis and portfolio management that have also been adapted to capital budgeting.
Finally, although analysts have a vantage point outside the company, their interest in valuation coincides with the capital budgeting focus of maximizing shareholder value. Because capital budgeting information is not ordinarily available outside the company, the analyst may attempt to estimate the process, within reason, at least for companies that are not too complex. Further, analysts may be able to appraise the quality of the company’s capital budgeting process—for example, on the basis of whether the company has an accounting focus or an economic focus.

This reading is organized as follows: Section 2 presents the steps in a typical capital budgeting process. After introducing the basic principles of capital budgeting in Section 3, in Section 4 we discuss the criteria by which a decision to invest in a project may be made.

Learning Outcomes

The member should be able to:

describe the capital budgeting process and distinguish among the various categories of capital projects;
describe the basic principles of capital budgeting;
explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing;
calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project;
explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods;
contrast the NPV decision rule to the IRR decision rule and identify problems associated with the IRR rule;
describe expected relations among an investment’s NPV, company value, and share price.

Summary

Capital budgeting is the process that companies use for decision making on capital projects—those projects with a life of a year or more. This reading developed the principles behind the basic capital budgeting model, the cash flows that go into the model, and several extensions of the basic model.

Capital budgeting supports the most critical investments for many corporations—their investments in long-term assets. The principles of capital budgeting have been applied to other corporate investing and financing decisions and to security analysis and portfolio management.
The typical steps in the capital budgeting process are: 1) generating ideas, 2) analyzing individual proposals, 3) planning the capital budget, and 4) monitoring and post-auditing.
Types of projects appropriate for the capital budgeting process can be categorized as: 1) replacement, 2) expansion, 3) new products and services, and 4) regulatory, safety and environmental.
Capital budgeting decisions are based on incremental after-tax cash flows discounted at the opportunity cost of funds. Financing costs are ignored because both the cost of debt and the cost of other capital are captured in the discount rate.
The net present value (NPV) is the present value of all after-tax cash flows, or

NPV=∑t=0nCFt(1+r)t

where the investment outlays are negative cash flows included in the CF_ts and where r is the required rate of return for the investment.
The IRR is the discount rate that makes the present value of all future cash flows sum to zero. This equation can be solved for the IRR:

∑t=0nCFt(1+IRR)t=0
The payback period is the number of years required to recover the original investment in a project. The payback is based on cash flows.
The discounted payback period is the number of years it takes for the cumulative discounted cash flows from a project to equal the original investment.
The average accounting rate of return (AAR) can be defined as follows:

AAR=Average net incomeAverage book value
The profitability index (PI) is the present value of a project’s future cash flows divided by the initial investment:

PI=PV of future cash flowsInitial investment=1+NPVInitial investment
The capital budgeting decision rules are to invest if the NPV > 0, if the IRR > r, or if the PI > 1.0 There are no decision rules for the payback period, discounted payback period, and AAR because they are not always sound measures.
The NPV profile is a graph that shows a project’s NPV graphed as a function of various discount rates.
For mutually exclusive projects that are ranked differently by the NPV and IRR, it is economically sound to choose the project with the higher NPV.
The “multiple IRR problem” and the “no IRR problem” can arise for a project with nonconventional cash flows—cash flows that change signs more than once during the project’s life.
The fact that projects with positive NPVs theoretically increase the value of the company and the value of its stock could explain the popularity of NPV as an evaluation method.