In a 2001 Graham and Harvey survey of 392 chief financial officers (CFOs) asked “how frequently they used different capital budgeting methods?” Approximately 75% of the CFOs replied that they use net present value (NPV) or Internal Rate of Return (IRR) always or almost always (Smart, Megginson & Gitman, 2004, pg. 251). Projects are viewed as capital investments in the corporate world, and as such, are evaluated closely for their possible financial impacts on the “bottom line” due to their higher risk of failure. Capital investments are those that are considered long-term investments such as manufacturing plants, R&D, equipment, marketing campaign, etc., and capital budgeting is “the process of identifying which of these investment projects a firm should undertake” (Smart, Megginson & Gitman, 2004, pg. 227). According to Smart, Megginson & Gitman, there are three steps in the capital budgeting process: * Identifying potential investments
* Analyzing the set of investment opportunities, identifying those that will create shareholder value, and perhaps prioritizing them * Implementing and Monitoring the investment projects selected This paper will focus on step two, and will discuss the strengths and weaknesses of the four most common methods that are utilized for evaluating, selecting and prioritizing projects in the corporate world. Net Present Value (NPV), Internal Rate of Return (IRR), Straight/Discounted Payback Period and Profitability Index are the four of the most come methods used during step 2 of the capital budgeting process. Four fictional potential capital investments will be used to illustrate how the different methods can affect project selection for a portfolio. THEME PARK CAPITAL INVESTMENTS
A theme park senior executive management team had four capital projects presented during the last capital budget meeting. The projects are a $250M park expansion, $50M value resort renovation, $500M new moderate resort construction and $200M new value resort construction. All these projects have similar completion time frames and have 20 year life expectancies. Years 1 to 5 cash flows for each project come from the pro formas, and Years 6 -20 are based on an expected 2% per increase in cash flows. The company has $750M to invest on capital projects this year, and they must decide which projects should be approved. NET PRESENT VALUE
Net Present Value is the sum of discounted future cash flows and provides the appropriate adjustments for the time value of money. In short, NPV is the reverse of compounding interest, and this process begins with the selection of a “discount rate.” According to Smart, Megginson & Gitman, pg. 301, “A project’s discount risk must be high enough to compensate investors for the project’s risk” The discount rate can be based on the inherent risk of a project, the required rate of return on shares, cost of equity, etc. The discount rate should not be one rate for all projects with in a firm, but reflect the nature of the project. The formula for NPV is:
In this calculation, CFt represents the net cash flow of the year and r is the selected discount rate. CF0 usually represents the initial outlay to get the project started, and is usually a negative cash flow. As a rule, projects with a negative NPV are not approved, but a “hurdle” could be set such as projects with a NPV <$100M will be dismissed.
The main strength of using NPV in project selection is that risk of each project analyzed can be accounted for differently by adjusting the discount rate. This means that more risky a project, the higher the discount rate applied to the calculation. Other strengths of NPV are that it focuses on cash flow instead of accounting earnings, firms would select projects that should have a positive impact on the firm, and it evaluates the life of the project instead of just the early...