When people hear the term capital budgeting, they usually focus on the budgeting part of the term rather than the capital portion. Actually, capital is the more important aspect in that it lets us know that we are evaluating a larger expenditure that will be capitalized -- in other words, depreciated over time. Remember, a capital expenditure can be many things -- a large copying machine, an automated assembly line, a building, or the ultimate in capital budgeting -- the acquisition of another entity. What is totally cool about capital budgeting is it allows you to analyze one or more projects so that you can intelligently and strategically make a decision as to which ...view middle of the document...
You also have a capital restraint of approximately $500K so you cannot purchase both entities. Thus, you provide your accountants and analysts with all of the historical financial details of both companies. They spend a few days taking that information and forecasting 5 years of detailed financial statements based on how your company would operate these two corporations. Below are the results that ended with the projected 5 year net cash flow figures. Year 0 shows the initial cost outlay (or purchase price), and years 1 through 5 shows the projected cash in flow if you make the purchase.
| |0 |1 |2 |3 |4 |5 |
| | | | | | | |
|ABC |-500 |100 |200 |575 |325 |100 |
| | | | | | | |
|XYZ |-500 |275 |250 |75 |250 |450 |
It is an interesting coincidence to note that if you total both rows for each company, they are the same. However, you know that this does not matter in that comparing totals ignores the time value of money and is not a valid capital budgeting tool in making strategic decisions for your firm.
Let's first look at two of the more popular capital budgeting tools, NPV and IRR. As we are doing, you always look at the projected cash flows for each project -- not net income. In order to compare the projects on equal terms, you bring back the future cash flows to the present, which is the present value concept. Then you subtract the cost of that project from its present value -- thus, net present value (NPV).
Before we start this process, we need a discount rate (the interest rate used in the NPV formula). Sometimes it is called the hurdle rate or required rate of return. It is usually the cost of capital (sometimes with a risk factor added, if it is a risky project). The cost of capital is used because you want this project to at least make more than what capital is now costing you to run your business -- otherwise, the project will lose the firm cash. In this example, we are using a discount rate of 10%. Thus, if your net present value is positive -- it is a good project. If it is negative, it is considered a "dog". In comparing projects, you want to pick the one with the highest NPV.
|NPV | |
| ABC |$472.28 |
| | |
| XYZ |$463.13 |
As you can see (of course, you are welcome to check these figures with your spreadsheet program or financial calculator) ABC has a slightly higher NPV. Therefore, ABC would be our choice based on this one capital budgeting tool. You should note that NPV is considered the most superior capital budgeting tool.
Now, how would you interpret or define our NPV answer? A...