Capital budgeting Process: WACC, payback, NPV, risk, ROA

Capital Budgeting

To help in this section a PowerPoint presentation “CAPITAL BUDGETING:
The Key Building Blocks”, which is an attachment to this email. You
can print off this lecture and then run the PowerPoint presentation as
you read along. There are 9 building blocks I will be taking you
though.

Investment Opportunity

Method of Investment

Capital Sources

Time Value of Money

Cost of Capital

Evaluation Techniques

Risk Adjustments

Accounting and Taxes

The Capital Budgeting Model

 

Investment Opportunities

Cost Reduction

Expansion

Compliance

Cost Reduction basically something that improves efficiency, speed, or
quality. If the new investment saves you money it is a cost reduction
opportunity. Usually these types of opportunities involve new equipment
or facilities, computers and programs, products, and even technology.
But I need to separate this category into something we are already doing
and just want to do it more efficiently. I am leaving completely new,
never been done here, type of projects for the expansion category.

Expansion projects are those that involve new products, locations,
technology, acquisitions, customers, computer applications, new etc.
These types of projects have never been done before in our company. We
are taking a bigger risk on these types of projects because of
inexperience and the unproven assumptions required for success.

Compliance projects involve those mandated by law. These compliance
projects may also affect costs and efficiency but normally they are
evaluated separately because of the lack of a pure “benefit” motive.
Some of these projects may be evaluated based on the avoidance of a
fine or tax so I guess you could call this a benefit if the project
helped us escape the cost

The second building block concerns the Method of Investment to be used
for the new project.

Purchase

Make

Lease

Rent

These decisions are made about any project. Since most end up as fixed
assets on the Balance Sheet, accounting systems track and accumulate
costs that are eventually “capitalized” meaning they are added to
the fixed assets in the company’s chart of accounts. And yes, these
fixed assets can and do include purchased items, the company’s own
labor, sub-contract costs, even shipping and instillation.

The third building block are the Capital Sources (money) coming from to
make this investment? Basically there are three sources:

Retained Earnings

Debt

New Equity

This decision is made at the top levels of the company as to how much to
budget for capital items and where the money is coming from. For our
purposes, we will not get into this budgeting process here. We will
assume the money is there. What is important to remember however is
projects are evaluated on a cost of capital basis which we will discuss
in a few moments. Most texts indicate that the source of money is not
specifically identified to a particular project. It is pooled and
considered part of the company’s overall cost of all capital.

Time Value of Money

Any capital project is an investment. The two categories are cost
reduction and expansion. Both have specific identifiable benefits and
costs.

Cost of Capital.

A business plan is based on how great it sounds (of course we have all
the legal documents and you are accredited investors) you and I write
checks totaling $100,000 for 100% of the shares in the company. In your
mind you felt this opportunity could return 20% pretax each year on your
investment. The next day I deposit the $100,000 equity in our bank
account and borrow another $100,000 from the bank at 10% annual
interest. What is our cost of capital now?

You will see that our weighted cost of capital is 15% calculated by
adding together 50% equity times 20% and 50% debt times 10%. If we do
make 15% pretax we can satisfy the bank and the shareholders.

Evaluation Techniques

These are divided into two basic camps: The “time value of money”
evaluation and the plain “give me my money back.” You may read and
get the opinion one is better than the other but what ever the method
used management still must make some basic and final decisions. The
methods don’t do this for you. Typical today in the companies;

 

Pay Back Period of less than 3 years

NPV at risk-adjusted WCC

IRR and PI to break ties and rationing

With the ever-shorter product life cycle and uncertain economic future
today, companies are taking a stronger look at quick pay back. For most
mainstream consumer and industrial products a pay back of less than 3
years is the first criteria a project must meet. If not, the project is
rejected regardless of the NPV or IRR. The second criteria are the NPV
at your weighted cost of capital adjusted for risk. I will talk about
risk in a moment. The project must have a zero or grater NPV to be
accepted. Finally, the IRR and PI techniques are used where multiple
projects compete for limited capital investment funds.

Risk Adjustment is recommended. Companies for the most part use a seat
of the pants approach to risk adjustment. So management just uses their
best judgment in most cases 1) Risked-adjusted WCC, and 2) Certainty
Equivalent (probability). And most companies differentiate between Cost
Reduction and Expansion projects feeling Expansion projects are much
more risky as we discussed earlier. So naturally these types of projects
have a greater risk adjustment. The risk adjustment in any case raises
the bar by reducing the potential return or increasing the interest rate
or discount factor. This makes the NPV criteria much harder to achieve
and thus is a way to compensate for the risk management feels is
present.

Discussion Question:

 

Why would a manager use the Weighted Cost of Capital for investment
decisions when a specific project may be funded by a particular source
of capital, (e.g. debt or equity)?

 

2. What capital budgeting process and evaluation does your organization
(or one you can talk to) use? Specifically what Pay Back Period and NPV
discount factor is used and how does the company adjust for risk? You
will probably need to ask someone in the financial department on this
one. 

3. If a company had a ROA percentage lower than its cost of capital
for a number of years what
problems would you look for in the Capital budgeting process?