Chapter 16
Using Capital Budgeting to Prepare for the Future
In This Chapter
Preparing for capital investments
Determining capital’s cost
Choosing the best capital investments
Purchasing machinery and equipment and building factories require spending today in order to receive future revenue. Thus, capital budgeting is one of the most important and yet uncertain decision-making areas because it’s critically influenced by time.
Capital budgeting decisions require a substantial amount of forecasting — I hope you have your crystal ball or Magic 8 ball handy. Biased or poorly developed forecasts adversely affect the quality of investment decisions. Therefore, techniques for evaluating capital investment projects have limited value in the absence of unbiased, well-developed forecasts.
In this chapter, I show you the critical components for evaluating alternative investment projects and selecting from them. That process includes understanding critical aspects of estimating future cash flows and procedures for determining the cost of capital. Understanding these critical components provides the foundation for comparing and evaluating alternative investment projects.
Investing in Capital
Economists define capital as the machinery, equipment, and factories you use in the production process. Investment refers to the purchasing of capital.
To an economist, buying stock on the New York Stock Exchange isn’t investment because you’re not buying an actual machine or building a factory.
Investment requires long-term decisions. You spend/invest money and incur a cost today in order to realize future revenue. Although they’re always long-term, investment decisions address different purposes and have different affects on the firm. Investment purposes include the following:
Replacement investment decisions are expenditures to replace existing machinery and equipment. A restaurant deciding to replace kitchen equipment and a firm replacing assembly line machinery are examples of replacement investment decisions.
Modernization investment decisions reduce production costs. A modernization decision emphasizes more efficient operation — it may involve the renovation of a factory or the installation of automated machinery.
Expansion investment decisions increase the firm’s productive capacity or introduce new products or markets. A firm’s decisions to build an additional factory or expand sales to a new region are examples of expansion decisions.
Operating investment decisions involve changes in inventories. Economists regard inventory as an investment because inventory represents goods produced but not immediately sold. A car dealer may increase the number of cars it keeps to interest new customers.
Seed investment decisions represent investment expenditures whose returns aren’t immediately realized. Typical seed investment decisions include expenditures into research and development, training, market research, and advertising.
Pollution-control or safety investment decisions include investments necessary for compliance with regulations established by government agencies such as the Environmental Protection Agency (EPA) and the Occupational Safety and Health Administration (OSHA). In addition, investments related to worker safety may be required by labor agreements or insurance policies.
Each type of investment decision represents an immediate cash outlay for some future revenue or benefit.
Selecting among Alternative Investments
You face a variety of investment opportunities at any given point of time; therefore, it’s important to develop criteria that enable you to choose among these projects. Determining which projects to undertake during a given period determines your firm’s current capital expenditures. In addition, the projects selected influence your firm’s future operations and profit.
In determining whether or not to invest in a project, you still maximize profits. To accomplish this goal, you undertake all investment projects that have marginal revenue exceeding marginal cost (MR>MC). In capital budgeting, the investment’s rate of return represents marginal revenue, while the firm’s cost of capital represents marginal cost.
Figure 16-1 illustrates the capital budgeting process. The investment return curve, IR, represents the anticipated return on various investment projects. The curve is disjointed, reflecting the different sizes and returns for various projects. For example, project A requires a $10 million investment and yields an expected 18-percent rate of return. Project B requires a $30 million investment — increasing the total capital investment to $40 million — and yields an expected 15-percent return. The downward tendency of the curve indicates that you undertake investment projects with highest expected return first.
The investment return curve in Figure 16-1 is disjointed, reflecting the fixed investment required for each project. Thus, project A requires a $10 million investment — a partial investment can’t be made.
Figure 16-1: Investment selection process.
The cost of capital curve, CC, indicates the marginal cost of obtaining each additional investment dollar. In Figure 16-1, this curve is horizontal until $30 million, representing a constant cost of capital at 8 percent. After $30 million, the curve slopes upward, indicating rising cost associated with the firm’s increasing debt load.
The firm’s optimal investment level corresponds to the intersection of the investment return curve and the cost of capital curve. In Figure 16-1, this corresponds to a total investment of $60 million.
In Figure 16-1, you spend $60 million on investment projects A, B, and C. The first $30 million invested costs 8 percent, and the marginal cost of the last dollar invested is 9 percent. You won’t invest in projects D and E because their expected return (IR) is less than the cost of the money invested (CC).
The actual capital budgeting process is more complicated than Figure 16-1 implies. First, proposals for potential investment projects have to be generated. Then you must estimate future cash flows and the cost of capital for those projects. With this information, you can evaluate the alternative investment proposals and determine which, if any, to pursue. Finally, after their implementation, projects are subject to ongoing review.
Estimating Cash Flows in an Uncertain Environment
Estimates of future cash flows — both cash receipts and expenditures — are a crucial element in any investment decision. Four important elements enter into the determination of future cash flows.
Cash flows must be determined on an incremental basis. Only include cash flows that are directly affected by whether or not the project is accepted.
All affected cash flows must be included in the calculation. An investment project’s impact on other activities of the firm must be included. For example, if a restaurant is evaluating a new menu item, it must consider the impact the item’s introduction has on the sales of current menu items.
Cash flows are determined on an after-tax basis. Estimated cash flows are dependent upon the firm’s marginal tax rate.
Because depreciation isn’t associated with a cash flow, it shouldn’t be directly included. However, any impact depreciation has on taxes is incorporated in cash-flow estimates.
As these elements indicate, the determination of cash flows is heavily dependent upon your accounting data.
Future cash-flow estimates may reflect forecaster’s biases, especially if the forecaster is very enthusiastic or unenthusiastic about the particular project. It’s important to carefully examine the assumptions underlying cash flow forecasts.
Budgeting for Capital
Firms raise investment funds through both internal and external sources. Methods for raising funds internally include using retained earnings or funds the owner contributes, while external financing includes borrowing money or issuing more stock. Regardless of how funds are raised, the firm incurs costs.
Determining the Cost of Capital
The cost of capital associated with external funds is easily recognized as the interest you have to pay on the borrowed funds. Internal funds represent using equity — either the firm’s or the firm’s owner’s financial resources — to finance the project. However, internal funds also cost you — even if you contribute those funds.
The opportunity cost of funds you invest in the firm is the interest you could have earned if you had invested those funds elsewhere. This cost is very real, and your investment project has to generate enough cash to offset this lost opportunity.
Using internal funds: I’ll pay for it myself
Because the cost of using internally generated funds or equity is the lost opportunity for you to invest these funds in the next best alternative, you must use a method that estimates the return the next best alternative generates. Typically, one of three methods — risk-premium, dividend-valuation, or capital-asset pricing — is used to determine the cost of internal or equity capital.
Risk-premium method
The risk premium method assumes that you incur some additional risk in the investment. This method’s cost estimation uses a risk-free rate of return, rf, plus an additional risk premium, rp, or
where ke is the cost of equity capital. It’s common to use the U.S. Treasury Bill rate as the risk-free rate of return (rf). The risk premium (rp) that’s added to the risk-free rate of return has two components. First, it includes the difference between the interest rate on company bonds as compared to the U.S. Treasury Bill rate. Second, it includes an additional premium reflecting the added risk of owning the specific company’s stock instead of its bonds. The risk premium has historically averaged four percent; however, this amount varies substantially among companies and over different length time periods.
Dividend-valuation method
The dividend valuation method uses shareholder attitudes to determine the cost of equity capital. Shareholder wealth is a function of dividends and changing stock prices. Therefore, a shareholder’s rate of return is a function of the ratio of the dividend, D, divided by the stock price per share, P, plus the expected or historic earnings growth, g. Using this shareholder return as the cost of equity capital results in
Your firm’s stock currently sells at $24.00 a share and the current annual dividend is $0.96. Your firm’s historic growth rate is 5 percent. Given this information, use the following steps to calculate the cost of equity capital by using the dividend-valuation method:
1. Determine the ratio of D/P.
This ratio determines the rate of return your invested funds earn through dividends.
2. Add the historic growth rate to the D/P ratio.
This determines the cost of equity capital by including the anticipated growth in the stock’s price.
Capital-asset-pricing method
The third method for estimating the cost of equity capital is the capital-asset-pricing method. This method incorporates a risk premium for variability in a company’s return. The risk premium is higher for stocks whose returns are more variable, and lower for stocks with stable returns. The formula used to determine the cost of equity capital using the capital-asset-pricing method is
where rf is the risk-free return, km is an average stock’s return, and β measures the variability in the specific firm’s common stock return relative to the variability in the average stock’s return. If β equals 1, the firm has average variability or risk. β values greater than 1 indicate higher than average variability or risk while values less than 1 indicate below average risk. The term β(km – rf) gives the risk premium for holding the firm’s common stock.
The return on U.S. Treasury bills is 2 percent and the average return on stock is 7 percent. Variability in your firm’s stock return relative to variability in the average stock’s return is 1.8. Given this information, the cost of equity capital using the capital-asset-pricing method is calculated through the following steps:
1. Determine the risk premium.
The risk premium is determined by subtracting the risk-free rate of return from the average stock’s return and multiplying by β.
2. Add the risk premium to the risk-free rate of return.
This addition determines the cost of equity capital by including the risk premium.
Relying on external funds: Help!
The cost of using external funds, or the cost of debt capital, is the interest rate you must pay lenders. However, because interest expenses are tax deductible, the after-tax cost of debt, kd, is the interest rate, r, multiplied by 1 minus the firm’s marginal tax rate, t, or
You’ve decided to finance a capital investment by issuing bonds that have a 6 percent annual interest rate. In addition, your company’s marginal tax rate is 35 percent. The cost of using debt to finance the project equals
Calculating the composite cost of capital
Firms commonly raise funds for capital investment from both internal and external sources. The composite cost of capital, kc, is a weighted average of the cost of equity capital and the cost of debt capital. Therefore,
where we and wd are the weights or proportions of equity and debt capital you use to finance the project.
You decide to fund a capital investment through a combination of equity and debt capital. You plan to fund 25 percent of your capital investment through equity and 75 percent through debt. To determine the composite cost of capital, start by separately calculating the cost of equity capital and the cost of debt capital. Assume your firm’s β coefficient is 2.1 and the average stock return is 6 percent. The return on U.S. Treasury bills is 1 percent, which is the risk-free rate of return. Your firm can borrow funds at 9-percent interest and its marginal tax rate is 34 percent.
1. Determine the cost of equity capital.
In this example, I’m using the capital-asset-pricing method.
2. Determine the cost of debt by using the marginal tax rate.
3. Determine the composite cost of capital.
Remember to weight each component by the percentage of funds raised through that method — equity or debt.
Thus, the composite cost of capital is 7.33 percent.
Avoiding pitfalls in capital budgeting
George Burns is credited with saying, “Look to the future, because that is where you’ll spend the rest of your life.” This quote is the essence of capital budgeting. But trying to guess the future makes it easy to make some common mistakes.
One common mistake is to overestimate your cost of capital. Business managers are often conservative, so they want to screen out all but the most promising projects. The consequence of this very conservative strategy is that profitable investment projects aren’t undertaken.
Another common error is for firms to assume profit levels won’t change even if capital investment isn’t undertaken. Because rival firms are investing, the lack of investment ultimately leads to profits eroding. Estimated cash flows should reflect this incremental difference. If they don’t, new project profitability is underestimated.
Firms must also be careful not to exclude qualitative factors. Investment may enable you to decrease production time, enabling you to fill customer orders in a more timely fashion. Although this impact is difficult to quantify, there’s no doubt that it positively affects your firm’s sales and profitability.
Finally, firms typically are too cautious with ambitious projects. Smaller investments are frequently undertaken with minimal management approval, while larger projects may require several levels of management approval. As a consequence, managers have an incentive to propose smaller rather than larger projects.
Evaluating Investment Proposals
After determining cash flows and the cost of capital, managers can begin to evaluate various investment alternatives. The most commonly employed technique for evaluating investment alternatives is the net present value technique. Variations of this technique include the profitability index and the internal rate of return.
Determining today’s net present value
The net present value (NPV) technique is based on the concept that you prefer receiving cash today rather than in the future. One obvious reason for this preference is the fact that cash received today can earn interest through the purchase of government securities or other types of bonds. Therefore, any future cash you receive needs to be discounted by an appropriate interest rate.
If all the capital investment project’s expenditures occur during the current year, the project’s net present value (NPV) equals
where CFt represents the net after-tax cash flow in year t, r is the cost of capital, and I is the capital investment project’s cash outlay assumed to occur in the current year, or year 0. I summarize the determination of r in the previous section.
If the capital investment project has any salvage value at the end of its use, the salvage value is included in the last year’s cash flow.
Any investment project with a positive net present value is profitable for the firm and should be undertaken.
You’re evaluating a capital investment project that generates cash flows the next four years. Net cash flow estimates are $18,000 the first year, $45,000 the second year, $50,000 the third year, and $12,000 the fourth and final year. The capital project’s initial investment is $105,000 and there is no salvage value at the end. Finally, the cost of capital is 8 percent. In order to determine whether or not to undertake the project, you take the following steps:
1. Determine the present value for the first year’s cash flow.
Divide the first year’s net cash flow by (1 + r)1.
2. Determine the present values for the second, third, and fourth years’ cash flow.
Note how the exponent changes in the denominator of the calculation.
3. Add the four years’ present values.
4. Determine the capital investment project’s net present value.
Subtract the initial investment required from the sum of the four years’ present values.
5. Don’t make the capital investment.
Because the project’s net present value is negative, you shouldn’t invest in the project.
You must consider the time value of money when investing in a capital project. In this example, the sum of the undiscounted net cash flows is $125,000, which is greater than the $105,000 required investment. But remember that money received in the future isn’t worth as much as money received today. Or, as an alternative to the project, you could buy a government bond today and earn 8-percent interest or $8,400 (0.08 × 105,000) annually.
Indexing profitability
The profitability index is a variation of the net present value technique. The profitability index (PI) is calculated as follows
where PI represents the profitability index, CFt represents the net after-tax cash flow in year t, r is the cost of capital, and I is the capital investment project’s cash outlay assumed to occur in the current year, or year 0.
Any project with a profitability index greater than 1 (PI>1)should be undertaken because the present value of its future cash flow exceeds the current investment — the numerator is larger than the denominator.
An important advantage of the profitability index is realized when circumstances prevent you from undertaking all profitable investments. In these situations, you use the profitability index to rank projects, undertaking projects with the highest profitability index first.
You’re evaluating a capital investment project that generates cash flows the next three years. Net cash flows are estimated to be $1 million the first year, $4 million the second year, and $3 million the third and final year. The capital project’s initial investment is $6 million and there is no salvage value at the end. Finally, the cost of capital is 10 percent. In order to determine whether or not to undertake the project, you take the following steps:
1. Determine the present value for the firm’s future net cash flow.
2. Divide the project’s present value of future cash flows by the project’s cost.
3. Because the profitability index is greater than 1, you should undertake the project.
An index value greater than 1 indicates the present value of future cash flows exceeds the project’s initial cost.
One problem with the profitability index is that it tends to be biased in favor of smaller projects. For example, a project that requires a $50,000 investment and has a present value of net cash flow equal to $60,000 has a profitability index of 1.20. On the other hand, a project requiring a $5,000,000 investment that has a present value of net cash flow equal to $5,500,000 has a profitability index of only 1.10. Clearly, the $500,000 additional profit from the second project is better than the $10,000 additional profit from the first project even though the second project has a lower profitability index.
Calculating the internal rate of return
Calculating the internal rate of return is another alternative application of the net present value technique. The internal rate of return is the interest rate that equates the project’s present value of future net cash flows with the project’s initial investment outlay. Mathematically,
The Normal is solved for r*, which represents the internal rate of return.
If the project’s internal rate of return exceeds the cost of capital, the firm should undertake the project. This is similar to the situation described earlier in Figure 16-1.
The solution for the internal rate of return when done by hand is typically a laborious trial-and-error process. However, computers can be used to quickly solve this type of problem.