Capital Budgeting and Valuation, Definitions, Examples and Processes

What is the capital budgeting?
Capital budgeting involves selecting projects that add value to the company. The capital budgeting process can include almost anything including the purchase of land or the purchase of fixed assets such as new trucks or machinery.

Companies are usually required, or at least recommended, to undertake those projects that will increase profitability and thus enhance shareholder wealth.

However, the rate of return which is considered acceptable or not is influenced by other factors specific to the company as well as to the project.

For example, a social or charitable project is often not approved based on the rate of return, but is more dependent on the company’s desire to promote goodwill and contribute to its community.

Main Points to take

  1. Capital budgeting is the process by which investors determine the value of a potential investment project.
  2. The three most common methods of project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV).
  3. The payback period determines how long it will take the company to see enough cash flow to recover the original investment.
  4. The internal rate of return is the expected return on the project – if the rate is higher than the cost of capital, it is a good project.
  5. The net present value shows how profitable the project is against the alternatives and is probably the most effective of the three methods.

Understanding the capital budget
Capital budgeting is important because it creates accountability and measurable. Any business that seeks to invest its resources in a project without understanding the risks and returns involved will be considered irresponsible by its owners or shareholders.

Furthermore, if a company has no way of measuring the effectiveness of its investment decisions, the company will likely have little chance of surviving in the competitive market.

Corporations (other than nonprofits) exist to earn profits. The capital budgeting process is a measurable way for companies to determine the long-term economic and financial profitability of any investment project.

Different companies use different evaluation methods to accept or reject capital budget projects. Although the net present value (NPV) method is the most convenient method among analysts, the internal rate of return (IRR) and the payback period (PB) method are also often used under certain circumstances. Managers can have the most confidence in their analysis when all three approaches refer to the same course of action.

How does the capital budget work?
When a decision is made about a company’s capital budget, one of its first tasks is to determine whether or not the project will prove profitable. Payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common methods for project selection.

Although the ideal solution to capital budgeting is that all three measures will indicate the same decision, these approaches often lead to contradictory results. Depending on management preferences and selection criteria, greater emphasis will be placed on one approach over the other. However, there are common advantages and disadvantages associated with the widely used evaluation methods.

Payback period
Payback period calculates the length of time required to recover the original investment. For example, if a capital budgeting project requires an initial cash outlay of $1 million, PB reveals the number of years cash inflows are required to equal the $1 million outflow. A short PB period is preferred because it indicates that the project will “pay for itself” in a smaller time frame.

Payback periods are typically used when liquidity is a major concern. If a company has only a limited amount of money, it may only be able to take on one major project at a time. Therefore, management will focus heavily on recovering its initial investment in order to undertake subsequent projects.

Another major advantage of using a PB is that it is easy to calculate once you have made a cash flow forecast.

There are drawbacks to using the balance sheet scale to determine capital budgeting decisions. First, the payback period does not represent the time value of money (TVM). The PB account simply provides a metric that places the same emphasis on the payments received in year one and year two.

Such a mistake violates one of the basic principles of finance. Fortunately, this problem can be easily modified by applying the discounted payback period model. Essentially, TVM’s discounted PB period factors and allows one to determine how long an investment will take to be redeemed based on the discounted cash flow.

Another drawback is that both payback periods and discounted payback periods ignore cash flows that occur at the end of the project’s life, such as salvage value. Thus, the balance sheet is not a direct measure of profitability.

Internal rate of return
The internal rate of return (or the expected return on a project) is the discount rate that would result in a net present value of zero. Since the net present value of a project is inversely related to the discount rate – if the discount rate increases, future cash flows become uncertain and thus become less valuable – the standard criterion for calculating the internal rate of return is the actual rate a company uses to discount its after-tax cash flows .
An IRR higher than WACC indicates that the capital project is a profitable endeavor and vice versa.
The IRR rule is as follows:
IRR > Cost of Capital = Project Acceptance
IRR < cost of capital = project rejection

The main advantage of implementing the internal rate of return as a decision-making tool is that it provides a benchmark for each project that can be evaluated by reference to the company’s capital structure. The internal rate of return usually produces the same types of decisions as NPV models and allows companies to compare projects based on returns on invested capital.

Although it is easy to calculate the IRR with either a financial calculator or software packages, there are some drawbacks to using this metric. Similar to the PB method, the IRR does not give a real sense of the value a project will add to the company – it simply provides a benchmark for projects to be accepted based on the company’s cost of capital.

The internal rate of return does not allow a proper comparison of the mutually exclusive projects; So the managers may be able to determine that both Project A and Project B are beneficial to the firm, but they will not be able to decide which is better if only one project is accepted.

Another error resulting from the use of the same IRR analysis appears when the cash flow flows from the project are unconventional, which means that there are additional cash flows after the initial investment. Unconventional cash flows are common in a capital budget because many projects require future capital expenditures for maintenance and repairs.

The internal rate of return is a useful evaluation metric when analyzing individual capital budget projects, not those that are mutually exclusive. They provide a better evaluation alternative to the participatory budgeting method, but they do not meet several key requirements.

Net Present Value
The NPV approach is the most intuitive and accurate appraisal approach to capital budgeting problems. Discounting after-tax cash flows by a weighted average cost of capital allows managers to determine whether a project will be profitable. And unlike the IRR method, NPVs reveal exactly how profitable the project is compared to the alternatives.

The NPV rule states that all projects with positive NPV should be accepted while negative projects should be rejected. If funds are limited and not all positive NPV projects can be started, projects with a high discounted value must be accepted.

Some of the major advantages of the NPV approach include its overall benefit and that NPV provides a direct measure of added profitability. It allows one to compare several mutually exclusive projects simultaneously, and although the discount rate is subject to change, a sensitivity analysis for NPV can usually indicate any huge potential future concerns.

Although the NPV approach is fairly criticized that the value-added figure does not take into account the overall size of the project, the Profitability Index (PI), a measure derived from discounted cash flow calculations, can easily fix this concern.

The profitability index is calculated by dividing the present value of future cash flows by the initial investment. A PI greater than 1 indicates a positive NPV while a PI less than 1 indicates a negative NPV. Calculating a weighted average cost of capital (WACC) can be difficult, but it’s a powerful way to measure investment quality.

What is Valuation?
Valuation is the analytical process of determining the present (or expected) value of an asset or company. There are many methods used to perform the assessment. An analyst who places a value on a company considers running the business, the composition of its capital structure, the potential for future earnings, and the market value of its assets, among other metrics.

Fundamental analysis is often used in valuation, although several other methods such as the Capital Asset Pricing Model (CAPM) or the Discount Dividend Model (DDM) can be used.

The two main categories of Valuation methods

  • Absolute valuation models:  Attempt to find the intrinsic or “true” value of an investment based only on the fundamentals. Looking at the basics simply means that you will only focus on things like dividends, cash flow, and growth rate for one company, and not worry about any other. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.

 

  • Relative valuation models, in contrast, work by comparing the company in question to other similar companies. These methods involve calculating multipliers and ratios, such as the price-to-earnings multiplier, and comparing them to the multipliers of similar firms.

For example, if the P/E of a firm is less than the P/E multiple of a similar firm, the original firm may be considered undervalued. Calculating the relative valuation model is usually much easier and faster than calculating the absolute valuation model, which is why many investors and analysts begin their analysis with this model.

How earnings affect valuation
The earnings per share (EPS) formula is defined as the earnings available to common shareholders divided by the number of common shares outstanding. EPS is an indicator of a company’s earnings because the more earnings a company can generate per share, the more valuable each share is to investors.

Analysts also use a price-to-earnings (P/E) ratio to value stocks, which is calculated based on the stock’s market price divided by EPS. The price-to-earnings ratio calculates how much the share price will cost in relation to the earnings per share.

For example, if the P/E ratio is 20 times earnings, the analyst compares the P/E ratio with other companies in the same industry and with the ratio for the broader market. In equity analysis, the use of ratios such as P/E to value a company is called multiples-based valuation or multiples approach. Other multiples, such as EV/EBITDA, are compared with similar companies and historical multiples to calculate intrinsic value.

Valuation methods
There are different ways to conduct an assessment. The discounted cash flow analysis mentioned above is one way to calculate the value of a business or asset based on its potential earnings. Other methods include looking at past and similar transactions to company purchases or assets, or comparing a company with similar businesses and their valuations.

Comparable company analysis is a method that looks at similar companies, by size and industry, and how they trade to determine the fair value of a company or asset. The prior transaction method looks at the past transactions of similar companies to determine the appropriate value. There is also the asset-based valuation method, which aggregates all of the company’s asset values, assuming they are sold at fair market value, to obtain the intrinsic value.

Sometimes doing all these things and then weighing each is appropriate to calculate the intrinsic value. Meanwhile, some methods are more suitable for some industries and not others. For example, you wouldn’t use the asset-based valuation approach to value a consulting firm that has few assets; Alternatively, an earnings-based approach such as the discounted cash flow model would be more appropriate.

Discounted cash flow Valuation
Analysts also place a value on an asset or investment using the cash inflows and outflows generated by the asset, called discounted cash flow (DCF) analysis. These cash flows are discounted to the present value using the discount rate, which is an assumption about interest rates or the minimum rate of return that the investor assumes.

If the company is buying a piece of machinery, the company analyzes the cash flow for the purchase and the additional cash flow generated by the new asset. All cash flows are discounted to the present value, and the business determines the net present value (NPV). If the NPV is a positive number, the company must make the investment and buy the asset.

Limitation of Valuation
When deciding which valuation method to use to value a stock for the first time, it’s easy to become overwhelmed by the number of valuation techniques available to investors. There are fairly straightforward assessment methods while others are more complex and complex.

Unfortunately, there is no one-size-fits-all method. Every stock is different, and every industry or sector has unique characteristics that may require multiple valuation methods. At the same time, different valuation methods will produce different values ​​for the same underlying asset or company which may prompt analysts to use the technique that provides the best results.

Those interested in learning more about valuation and other financial topics may want to consider enrolling in one of the best personal finance classes.