# Why is the capital budgeting process so important

## Capital Budgeting Methodology: The Financial Analysis Stage

LEARNING OBJECTIVES After studying this chapter, you should be able to:

1. Discuss the discounted cash flow methods, and explain the net present value (NPV), internal rate of return (IRR), and present value index (PVI) methods.

2. Discuss the nondiscounted cash flow methods, which are the payback period (PP) method and the accounting rate of return (ARR) method.

3. Describe the impact of income taxes, purchasing versus leasing, and inflation on capital budgeting financial analysis.

4. Explain how sensitivity analysis assists managers in making capital budgeting decisions.

Introduction

Once the first stage of the capital budgeting methodology (covered in the previous chapter) has linked capital projects with an enterprise's vision and strategy, and estimated the quantity and timing of cash flows, the data are subjected to financial analysis. Using financial analysis methods (the second stage of the capital budgeting methodology), managers evaluate and compare alternative projects included in the Capital Projects Portfolio Statement. Such candidate capital projects will usually differ in the amount of initial investment required, terms of useful life, amount and timing of cash flows, salvage value, and cost of capital.

Two types of capital budgeting financial analysis methods are covered in this chapter:

Discounted cash flow methods Nondiscounted cash flow methods .

Discounted Cash Flow Methods

The main methods that managers use to financially analyze capital projects are called discounted cash flow (DCF) methods, which include the following:

Net present value (NPV) method Internal rate of return (IRR) method Present value index (PVI) method

These methods rely on the time value of money, a concept that combines two basic principles:

A dollar today is worth more than a dollar in the future (the idea of present value). The longer one waits for a dollar, the more uncertain the receipt is (the idea of risk).

Methods that incorporate the time value of money are dependent on a discount rate, which is based on cost of capital.

###### Discuss the discounted cash flow methods, and explain the net present value (NPV), internal rate of return (IRR), and present value index (PVI) methods.

The Cost Of Capital And The Discount Rate

Most authorities lean toward some type of weighted-average cost of capital, which is viewed as a pool of capital investment funds that come from debt and equity sources. The correct weighted-average cost of capital is the one that reflects an enterprise's expected financing costs for its desired long-term capital structure mix. Under this approach, the weighted-average cost of capital reflects market conditions for securing incremental financing and enables an enterprise to evaluate its capital structure based on future events. New projects being evaluated must earn a rate of return equal to or higher than the marginal cost of capital in order to maintain or increase the value of an enterprise. Alternatively, weighted-average cost of capital based on historical capital sourcing values may not be relevant to future sources of investment funds.

Given a mix of debt, preferred stock, common stock, retained earnings, and recovered capital, a weighted-average cost of capital can be calculated. To do this, the cost of raising a dollar from each source in the capital investment pool is estimated and weighted according to its proportion in the mix.

To measure the cost of debt,

the effective rate of interest that would have to be paid to acquire capital from new debt is used. The effective interest rate should be net of income taxes because interest is deductible for tax purposes.

Preferred stock usually has a contractual dividend rate. Consequently, this rate can be used to determine the effective cost of acquiring additional capital from the issuance of preferred stock. Unlike interest on debt, however, dividends are not deductible for income tax purposes. Thus, the effective rate is the annual contractual dividend per share divided by the estimated future share price.

The most troublesome aspect of calculating cost of capital is determining the cost of the common equity component of capital. Authorities do not agree on how this should be done. Some argue that the proper rate is the expected earnings per share divided by the current market value of the stock. Others contend that the cost of common equity funds is a function of expected dividends and expected share price. This theory must allow for an expected growth in dividend payments.

For capital resulting from retained earnings and capital recoveries (from depreciation), it must be recognized that shareholders do not pay income tax on undistributed assets. Presumably, shareholders would be willing to accept a smaller return on this source of capital than on common stock.

Exhibit 23-1 illustrates the cost of capital calculations for Cyberlink Corporation using a traditional internally-focussed method. There are other ways to compute the WACC that you will learn in your finance classes. The interest rate on debt is expected to be 10 percent, and debt is 20 percent of the sources of capital funds. Cyberlink's income tax rate is expected to be 40 percent over the next number of years. Preferred stock contributes up to 10 percent of capital funds, and its effective rate is expected to be 12 percent. Common stock comprises 40 percent of capital funds at an estimated future cost of 18 percent. Retained earnings and recovered capital provide 30 percent of capital funds at an estimated future cost of 16 percent. Based on the computations in the exhibit, Cyberlink's expected weighted-average cost of capital is 14.4 percent. This means that it will cost Cyberlink an average of 15 percent (rounded up) of each dollar annually to finance capital projects.

A discount rate, also referred to as a hurdle rate, should, in most cases, equal or exceed the enterprise's cost of capital. In other words, the discount rate is the required rate of return.

Some managers set the discount rate higher than the cost of capital because they recognize that indirect costs sometimes increase as the enterprise expands. Also, some capital projects are riskier than others because their outcome is more difficult to estimate. Managers will need some type of counterbalance or cushion for accepting the riskier alternatives. This cushion frequently takes the form of a higher discount rate. For example, in the case of Cyberlink, the discount rate for a low-risk project may be set at 12 percent (less than the cost of capital); for a moderate-risk project, 15 percent; for an average-risk project, 16 percent; for a high-risk project, 20 percent; and for an unchartered, super high-risk project, 30 percent or more. Because of the compounding nature of discounted cash flow methods, this method of adjusting for risk implicitly assumes that risk increases over time.