In general, projects do not simply come into existence generating cash inflows. Instead, most projects require some level of capital expenditure to get started. Capital expenditure represents the cash used to buy manufacturing tools and facilities, carry out R&D and marketing, and do various other activities that are needed for a project to produce positive cash flows in the future. As a result of this, capital is one of the critical aspects needed by almost all firms: even dotcom firms need to buy domain names and carry out advertising. The importance of capital in the successful operation of firms means that many businesses, particularly large firms, will pay great attention to ensuring that their capital is only used on the most important projects. The process of selecting these projects is called capital budgeting.
The process of capital budgeting will depend a lot on the preferences of the specific firm and its owners. Some shareholders will demand an immediate positive return from projects to recover their costs, whilst others want a project that produces sustained long term profits even if there is a small loss in the short term. To balance these conflicting demands, mathematical methods have been created to analyse the potential uses for the firm’s capital.
One method by which firms can budget their capital is by working out the net cash flow from a project over a certain period of time. For example, if a project requires capital investments of £1 million in the first year, but provides cash flows of £400,000 per year for the next three years, then it produces a net positive cash flow of £200,000. This approach has the advantage of being very simple, particularly for projects with lots of different cash flows coming in at different times. However, it does not take account of the fact that money received in the future tends to have a lower present value than money spent today, due to the impact of the time value of money.
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A second method is referred to as the payback period. This method aims to determine how long it will take a project to recoup all capital it has expended. For example, in the project above, the net cash flow will be -£600,000 after the first cash inflow, £-200,000 after the second and +£200,000 after the third. Therefore, the payback period will be three years, as the project repays all its capital to the firm after three years of operation. This approach is useful for the type of shareholders discussed above, who simply want to ensure that they get their initial investment back as soon as possible. However, it does not take account of the time value of money, and nor does it consider any cash flows which occur after payback. For example, there could be two projects with cash flows similar to the one above, but in the fourth year one of them has a net positive cash flow of £500,000 and the other one has a net negative cash flow of -£500,000. The payback period method would not distinguish between either of them.
A third method is to use the present and future value concept discussed above to produce a net present value, or NPV, for a project. The NPV concept is based on the premise that shareholders want any capital invested in a firm to achieve a certain percentage return. This return is referred to as the cost of capital, and is used as the interest rate, i, in calculating the present value of all future cash flows. Therefore, when using the NPV approach to calculate whether a project should be undertaken, a business will project its expected future cash flows from the project and discount them to their present value according to the firm’s cost of capital. The sum of all the present values, including the initial capital, gives the net present value of the project. If the NPV is positive, the project is accepted and if not it is rejected. NPV has the advantage that it takes account of the shareholders’ specific requirements for returns and their time value of money. NPV also provides a good basis for deciding between different projects. However, NPV can be very time consuming to calculate, particularly for projects with lots of capital inflows, and they also require firms to know their cost of capital which, in the real world where capital rates can change rapidly, is not always possible.
The final common method, which is often used to overcome some of the deficits of NPV, is the internal rate of return, or IRR of the project. The IRR is defined as the cost of capital at which the NPV of the project will be zero. It can be calculated by choosing two costs of capital, ideally one with a positive and one with a negative NPV, and using the following formula:
IRR = a + A(b - a) / (A - B)
Where A is the NPV at discount rate a and B is the NPV at discount rate B. Alternatively, Microsoft Excel and other spreadsheet programs can be used to calculate the IRR based on a series of cash flows and dates. This involves an iterative process.
The main advantage of IRR is that it gives a firm a simple rule for a project: if the cost of capital is lower than the IRR, the project should proceed and if it is higher the project should be rejected. This is useful in real life situations because the cost of capital available, in terms of loans and other sources of finance, can vary on a daily basis. As such, by the time an NPV has been calculated the cost of capital may have changed, requiring another calculation. In contrast, the IRR is independent of the cost of capital of the project and allows a firm to make an instant decision based on available market finance. However, the main drawback of IRR is that it does not provide a clear distinction between two projects at a given cost of capital, and projects requiring more than one inflow of capital may have two IRR values.