Capital Budgeting

Manufacturing businesses require fixed assets to generate revenue and profits. When a company grows it sometimes finds that in order to continue growing it must make some capital budgeting decisions. Capital budgeting is the process of analyzing projects to see if they should be included in the capital budget. A company may face a decision of upgrading equipment or buying new equipment to meet the demand for its products. A company may need to expand their building or build a new plant to allow for continued growth. These two situations I described would be what is called mutually exclusive. You would choose one or the other; upgrade or buy, expand or build, depending on which would be the most profitable.

The next step is taking two alternatives that are mutually exclusive and calculating the profitability of both to decide on the best alternative. Each alternative has a cost and relevant cash flows that have to be calculated. If I upgrade my equipment it is going to cost me X dollars today and provide relevant cash flows of X, Y, and Z over the next three years. I can take those three cash flows and discount them using the Weighted Average Cost of Capital back to day one and subtract the investment cost. That is called Net Present Value (NPV). If that is positive then it would be a profitable investment. The NPV for both alternatives would have to be calculated and the one with the highest NPV would be the most profitable investment.

Most of the Fortune 500 companies use the Internal Rate of Return (IRR) to make capital decisions. The IRR is that rate which when used to discount future relevant cash flows equals the investment cost. That is the equivalent of the NPV being zero. If the IRR is equal to the Cost of Capital then it is a break-even project. One that is probably not worth the time and effort. If the IRR is greater than the Cost of Capital then it is a profitable investment.

Which is a better indicator of a capital project's profitability, NPV or IRR? That is not a simple answer. In summary, the NPV implicitly assumes that cash flows can be reinvested at the cost of capital rate, whereas the IRR assumes that cash flows can be reinvested at the IRR. The better assumption is that cash flows can be reinvested at the cost of capital which means NPV is more reliable.

While NPV may be more reliable, as I mentioned before managers would rather use IRR because it is easier to communicate a project's profitablity in terms of percentage return on investment versus dollars of NPV. There are some inherent limitations with IRR when cash flows are negative and then turn back positive. When this happens you have multiple IRR's which makes it impossible to communicate an investment's return. Given this limitation, the IRR can be modified to provide a better indicator of profitability. The measure is called modified IRR or MIRR. MIRR is caculated by taking the present value of the cash outflows discounted using the WACC, and calculating the compounding future value of cash inflows. The compounded value of future cash inflows is sometimes referred to as Terminal Value, or TV. The discount rate that makes the present value of the TV equal the present value of the cash outflows is referred to as the MIRR.

Next week I will cover some alternative measures for calculating the profitability of capital projects.