Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
2 Capital Budgeting Under
Conditions Of Certainty
Introduction
The decision to invest is the mainspring of financial management. A project’s acceptance should produce
future returns that maximise corporate value at minimum cost to the company.
We shall therefore begin with an explanation of capital budgeting decisions and two common investment
methods; payback (PB) and the accounting rate of return (ARR).
Given the failure of both PB and ARR to measure the extent to which the utility of money today is greater
or less than money received in the future, we shall then focus upon the internal rate of return (IRR)
and net present value (NPV) techniques. Their methodologies incorporate the time value of money by
employing discounted cash flow analysis based on the concept of compound interest and a firm’s overall
cut-off rate for investment.
For speed of exposition, a mathematical derivation of an appropriate cut-off rate (measured by a
company’s weighted average cost of capital, WACC, explained in Part One) will be taken as given until
Chapter Three of the follow up SFM text. For the moment, all you need to remember is that in a mixed
market economy firms raise funds from various providers of capital who expect an appropriate return
from efficient asset investment. And given the assumptions of a perfect capital market with no barriers
to trade (also explained in Part One) managerial investment decisions can be separated from shareholder
preferences for consumption or investment without compromising wealth maximisation, providing all
projects are valued on the basis of their opportunity cost of capital.
As we shall discover, if the firm’s cut-off rate for investment corresponds to this opportunity cost, which
represents the return that shareholders can earn elsewhere on similar investments of comparable risk:
Projects that generate a return (IRR) greater than their opportunity cost of capital will
have a positive NPV and should be accepted, whereas projects with an inferior IRR
(negative NPV) should be rejected.
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
2.1 The Role of Capital Budgeting
The financial term capital is broad in scope. It is applied to non-human resources, physical or monetary,
short or long. Similarly, budgeting takes many forms but invariably comprises the detailed, quantified
planning of a scarce resource for commercial benefit. It implies a choice between alternatives. Thus, a
combination of the two terms defines investment and financing decisions which relate to capital assets
which are designed to increase corporate profitability and hence value.
To simplify matters, academics and practitioners categorise investment and financing decisions into long-
term (strategic) medium (tactical) and short (operational). The latter define working capital management,
which represents a firm’s total investment in current assets, (stocks, debtors and cash), irrespective of
their financing source. It is supposed to lubricate the wheels of fixed asset investment once it is up and
running. Tactics may then change the route. However, capital budgeting proper, by which we mean fixed
asset formation, defines the engine that drives the firm forward characterised by three distinguishing
features:
Longer term investment; larger financial outlay; greater uncertainty.
Combined with inflation and changing economic conditions, uncertainty complicates any investment
decision. We shall therefore defer its effects until Chapter Four having reviewed the basic capital budgeting
models in its absence.
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
With regard to a strategic classification of projects we can identify:
-- Diversification defined in terms of new products, services, markets and core technologies
which do not compromise long-term profits.
-- Expansion of existing activities based on a comparison of long-run returns which stem from
increased profitable volume.
-- Improvement designed to produce additional revenue or cost savings from existing
operations by investing in new or alternative technology.
-- Buy or lease based on long-term profitability in relation to alternative financing schemes.
-- Replacement intended to maintain the firm’s existing operating capability intact, without
necessarily applying the test of profitability.
2.2 Liquidity, Profitability and Present Value
Within the context of capital budgeting, money capital rather than labour or material is usually the
scarce resource. In the presence of what is termed capital rationing projects must be ranked in terms of
their net benefits compared to the costs of investment. Even if funds are plentiful, the actual projects
may be mutually exclusive. The acceptance of one precludes others, an obvious example being the most
profitable use of a single piece of land. To assess investment decisions, the following methodologies are
commonly used:
Payback; Accounting Rate of Return); Present Value (based on the time value of money).
Payback (PB) is the time required for a stream of cash flows to cover an investment’s cost. The project
criterion is liquidity: the sooner the better because of less uncertainty regarding its worth. Assuming
annual cash flows are constant, the basic PB formula is given in years by:
(1) PB = I0/Ct
PB = payback period
I0 = capital investment at time period 0
Ct = constant net annual cash inflow defined by t = 1
Management’s objective is to accept projects that satisfy their preferred, predetermined PB.
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
Activity 1
Short-termism is a criticism of management today, motivated by liquidity, rather than profitability,
particularly if promotion, bonus and share options are determined by next year’s cash flow (think
sub-prime mortgages). But such criticism can also relate to the corporate investment model.
For example, could you choose from the following using PB?
Cashflows Year 0 Year 1 Year 2 Year 3
(£000s)
Project A (1000) 900 100 -
Project B (1000) 100 900 100
The PB of both is two years, so rank equally. Rationally, however, you might prefer Project B because it
delivers a return in excess of cost. Intuitively, I might prefer Project A (though it only breaks even) because
it recoups much of its finance in the first year, creating a greater opportunity for speedy reinvestment.
So, whose choice is correct?
Unfortunately, PB cannot provide an answer, even in its most sophisticated forms. Apart from risk
attitudes, concerning the time periods involved and the size of monetary gains relative to losses, payback
always emphasises liquidity at the expense of profitability.
Accounting rate of return (ARR) therefore, is frequently used with PB to assess investment profitability.
As its name implies, this ratio relates annual accounting profit (net of depreciation) to the cost of
the investment. Both numerator and denominator are determined by accrual methods of financial
accounting, rather than cash flow data. A simple formula based on the average undepreciated cost of
an investment is given by:
(2) ARR = Pt – Dt / [(I0 – Sn)/2]
ARR = average accounting rate of return (expressed as a percentage)
Pt = annual post-tax profits before depreciation
Dt = annual depreciation
I0 = original investment at cost
S0 = scrap or residual value
The ARR is then compared with an investment cut-off rate predetermined by management.
Activity 2
If management desire a 15% ARR based on straight-line depreciation, should the
following five year project with a zero scrap value be accepted?
I0 = £1,200,000 Pt = £400,000
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
Using Equation (2) the project should be accepted since (£000s):
ARR = 400 – 240 = 26.7% > 15%
(1,200 – 0) / 2
The advantages of ARR are its alleged simplicity and utility. Unlike payback based on cash flow, the
emphasis on accounting profitability can be calculated using the same procedures for preparing published
accounts. Unfortunately, by relying on accrual methods developed for historical cost stewardship reports,
the ARR not only ignores a project’s real cash flows but also any true change in economic value over
time. There are also other defects:
-- Two firms considering an identical investment proposal could produce a different ARR
simply because specific aspects of their accounting methodologies differ, (for example
depreciation, inventory valuation or the treatment of R and D).
-- Irrespective of any data weakness, the use of percentage returns like ARR as investment or
performance criteria, rather than absolute profits, raises the question of whether a large
return on a small asset base is preferable to a smaller return on a larger amount?
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
Unless capital is fixed, the arithmetic defect of any rate of return is that it may be increased by reducing
the denominator, as well as by increasing the numerator and vice versa. For example, would you prefer
a £50 return on £100 to £100 on £500 and should a firm maximise ARR by restricting investment to
the smallest richest project? Of course not, since this conflicts with our normative objective of wealth
maximisation. And let us see why.
Activity 3
Based on either return or wealth maximisation criteria, which of the following projects
are acceptable given a 14 percent cut-off investment rate and the following assumptions:
Capital is limited to £100k or £200k. Capital is variable. Projects cannot be replicated.
£000s) A B C D
Investment (100) (100) (100) (100)
Return 10 15 20 25
We can summarise our results as follows:
Capital Rationing Variable Capital
Capital (£100,00) (£200,000)
Investment criteria ARR Wealth ARR Wealth ARR Wealth
Project acceptance D D D C,D D B,C,D
Return % 25% 25% 25% 22.5% 25% 20%
Profit (£000s) 25 25 25 45 25 60
When capital is fixed at £100,000, ARR and wealth maximisation equate. At £200,000 they diverge.
Similarly, with access to variable funds the two conflict. ARR still restricts us to project D, because the
acceptance of others reduces the return percentage, despite absolute profit increases. But isn’t wealth
maximised by accepting any project, however profitable?
Present Value (PV) based on the time value of money concept reveals the most important weakness of
ARR (even if the accounting methodology was cash based and capital was fixed). By averaging periodic
profits and investment regardless of how far into the future they are realised, ARR ignores their timing
and size. Explained simply, would you prefer money now or later (a “bird in the hand” philosophy)?
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
Because PB in its most sophisticated forms also ignores returns after the cut-off date, there is an
academic consensus that discounted cash flow (DCF) analysis based upon the time value of money and
the mathematical technique of compound interest is preferable to either PB and ARR. DCF identifies
that finance is a scarce economic commodity. When you require more money you borrow. Conversely,
surplus funds may be invested. In either case, the financial cost is a function of three variables:
-- the amount borrowed (or invested),
-- the rate of interest (the lender’s rate of return),
-- the borrowing (or lending) period.
For example, if you borrow £10,000 today at ten percent for one year your total repayment will be £11,000
including £1,000 interest. Similarly, the cash return to the lender is £1,000. We can therefore define the
present value (PV) of the lender’s investment as the current value of monetary sums to be received (or
repaid) at future dates. Intuitively, the PV of a ten percent investment which produces £11,000 one year
hence is £10,000.
Note this disparity has nothing to do with inflation, which is a separate phenomenon. The value of money
has changed simply because of what we can do with it. The concept acknowledges that, even in a certain
world of constant prices, cash amounts received or paid at various future dates possess different present
values. The link is a rate of interest.
Expressed mathematically, the future value (FV) of a cash receipt is equivalent to the present value (PV)
of a sum invested today at a compound interest rate over a number of periods:
(3) FVn = PV (1 + r)n
FVn = future value at time period n
PV = present value at time period zero (now)
r = periodic rate of interest (expressed as a proportion)
n = number of time periods (t = 1, 2, ..n).
Conversely, the PV of a future cash receipt is determined by discounting (reducing) this amount to a
present value over the appropriate number of periods by reference to a uniform rate of interest (or
return). We simply rearrange Equation (3) as follows:
(4) PVn = FVn / (1+r)n
If variable sums are received periodically, Equation (4) expands. PV is now equivalent to an amount
invested at a rate (r) to yield cash receipts at the time periods specified.
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
Q
39Q 6&W U W
W
PVn = present value of future cash flows
r = periodic rate of interest
n = number of future time periods (t = 1, 2 …n)
Ct = cash inflow receivable at future time period t.
When equal amounts are received at annual intervals (note the annuity subscript A) the future value of
Ct per period for n periods is given by:
)9$Q &W U Q
U
Rearranging terms, the present value of an annuity of Ct per period is:
39$Q &W U Q Ct/r for a perpetual annuity if n tends to infinity (∝).
U
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
If these equations seem daunting, it is always possible formulae tables based on corresponding future
and present values for £1, $1 and other currencies, available in most financial texts.
Activity 4
Your bankers agree to provide £10 million today to finance a new project. In return
they require a 12 per cent annual compound rate of interest on their investment,
repayable in three year’s time. How much cash must the project generate to break-
even?
Using Equation (3) or compound interest tables for the future value of £1.00 invested at 12 percent over
three years, your eventual break- even repayment including interest is (£000s):
(3) FVn = £10,000 (1.12)3 = £10,000 × 1.4049 = £14,049
To confirm the £10k bank loan, we can reverse its logic and calculate the PV of £14,049 paid in three
years. From Equation (4) or the appropriate DCF table:
(4) PVn = £14,049/(1.12)3 = £14,049 × 0.7117 = £10,000
Activity 5
The PV of a current investment is worth progressively less as its returns becomes more
remote and/or the discount rate rises (and vice versa). Play about with Activity 4 data
to confirm this.
2.3 The Internal Rate of Return (IRR)
There are two basic DCF models that compare the PV of future project cash inflows and outflows to an
initial [Link] present value (NPV) incorporates a discount rate (r) using a company’s rate of return,
or cost of capital, which reduces future net cash inflows (Ct) to a PV to determine whether it is greater
or less than the initial investment (I0). Internal rate of return (IRR) solves for a rate, (r) which reduces
future sums to a PV equal to an investment’s cost (I0), such that NPV equals zero. Mathematically, given:
Q
39Q 6&W U W 139 39Q, 139 39 ,ZKHUHU ,55
W
The IRR is a special case of NPV, namely a hypothetical return or maximum rate of interest required to
finance a project if it is to break even. It is then compared by management to a predetermined cut-off
rate. Individual projects are accepted if:
IRR ≥ a target rate of return: IRR > the cost of capital or a rate of interest.
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
Collectively, projects that satisfy these criteria can also be ranked according to their IRR. So, if our
objective is IRR maximisation and only one alternative can be chosen, then given:
IRRA > IRRB > …IRRN we accept project A.
Activity 6
A project costs £172,720 today with cash inflows of zero in Year 1, £150,000 in Year 2 and
£64,900 in Year [Link] an 8 per cent cut-off rate, is the project’s IRR acceptable?
Using Equation (8) or DCF tables, the following figures confirm a break-even IRR of 10 per cent
(NPV = 0). So, the project’s return exceeds 8 per cent (i.e. NPV is positive at 8 per cent) more of which
later.
Year Cashflows DCF Factor (10%) PV
0 (172.72) 1.0000 (172.72)
1 - 0.9091 -
2 150.00 0.8264 123.96
3 64.90 0.7513 48.76
NPV Nil
Unsure about IRR or NPV? Remember NPV is today’s equivalent of the cash surplus at the end of a
project’s life. This surplus is the project’s net terminal value (NTV). Thus, if project cash flows have been
discounted at their IRR to produce a zero NPV, it follows that their NTV (cash surplus) built up from
compound interest calculations will also be zero. Explained simply, you are indifferent to £10 today and
£11 next year with a 10 per cent interest rate.
(9) NPV = NTV / (1 + r) n ; NTV = NPV (1 + r)n ; NPV = NTV = 0, if r = IRR
2.4 The Inadequacies of IRR and the Case for NPV
IRR is supported because return percentages are still universally favoured performance metrics. Moreover,
computational difficulties (uneven cash flows, the IRR is indeterminate, or not a real number) can now
be resolved mathematically by commercial software. Unfortunately, these selling points overstate the
case for IRR.
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
IRR (like ARR) is a percentage averaging technique that fails to discriminate between project cash
flows of different timing and size, which may conflict with wealth maximisation in absolute cash terms.
Unrealistically, the model also assumes that even if cash data is certain:
-- All financing will be undertaken at a borrowing rate equal to the project’s IRR.
-- Intermediate net cash inflows will be reinvested at a rate of return equal to the IRR.
The implication is that capital cost and reinvestment rates equal the IRR, which remains constant over
the project’s life to produce a zero NPV. However, relax one or other assumption and IRR changes. So,
why calculate a hypothetical IRR, which differs from real world cut-off rates that can be incorporated
into the DCF model to determine whether a project’s actual NPV or NTV is positive or negative?
The IRR is a “castle built on sand” without economic meaning unless we compare it to a company’s
desired rate of return or capital cost. Far better to discount project cash flows using one of these rates
to establish a true economic surplus in absolute money terms as follows:
Q
139 6&W U W, 139 39Q, 179 U Q
139 U Q
W
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Strategic Financial Management Capital Budgeting Under Conditions Of Certainty
Individual projects are accepted if:
NPV ≥ 0: NPV> 0; where the discount rate is either a return or cost of capital.
Collectively, projects that satisfy either criterion can also be ranked according to their NPV.
NPVA > NPVB > …NPVN we accept project A..
Of course, NPV, like IRR, still requires certain assumptions. Known investment costs, project lives,
cash flows and whatever discount rate, must all be factored into the NPV model. But note this is more
realistic. Capital cost and intermediate reinvestment rates now relate to prevailing returns, rather than
IRR, so there are fewer margins for error. NPV is near the truth by representing the possible money
surplus (NTV) you will eventually walk away with.
Review Activity
Using data from Activity 6 with its 8 per-cent cut-off rate and Equations 10–11, confirm
that the project’s NPV is £7,050 and acceptable to management because the life-time
surplus equals an NTV of £8,881.
2.5 Summary and Conclusions
We can tabulate the objective functions and investment criteria of PB, ARR, IRR and NPV with respect
to shareholder wealth maximisation as follows:
Model Wealth Max. Objective Investment Criteria
Payback Rarely Minimise Pa\yback Time
(Maximise liquidity)
ARR Rarely Maximise ARR Profitability percentage
IRR Rarely Maximise IRR Profitability percentage
NPV Likely Maximise NPV Absolute profits
Capital Budgeting Models
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