Tag Archives | capital budgeting

Net Present Value Method

See also:
Valuation Methods
Adjusted Present Value Method
Internal Rate of Return Method
Time Value of Money
Capital Budgeting Methods
Rule of 72

Net Present Value Definition

Net Present Value (NPV) is defined as the present value of the future net cash flows from an investment project. NPV is one of the main ways to evaluate an investment. The net present value method is one of the most used techniques; therefore, it is a common term in the mind of any experienced business person.


To improve the value of your company, identify and find solutions to those “destroyers” of value. Click the button to download your free “Top 10 Destroyers of Value“.

Download The Top 10 Destroyers of Value


Net Present Value Method Explanation

Net present value can be explained quite simply, though the process of applying NPV may be considerably more difficult. Net present value analysis eliminates the time element in comparing alternative investments. Furthermore, the NPV method usually provides better decisions than other methods when making capital investments. Consequently, it is the more popular evaluation method of capital budgeting projects.

When choosing between competing investments using the net present value calculation you should select the one with the highest present value.

If:

NPV > 0, accept the investment.
NPV < 0, reject the investment.
NPV = 0, the investment is marginal

Net Present Value Discount Rate

The most critical decision variable in applying the net present value method is the selection of an appropriate discount rate. Typically you should use either the weighted average cost of capital for the company or the rate of return on alternative investments. As a rule the higher the discount rate the lower the net present value with everything else being equal. In addition, you should apply a risk element in establishing the discount rate. Riskier investments should have a higher discount rate than a safe investment. Longer investments should use a higher discount rate than short time projects. Similar to the rates on the yield curve for treasury bills.

Other net present value discount rate factors include: Should you use before tax or after tax discount rates? AS a general rule if you are using before tax net cash flows then use before tax discount rates. After tax net cash flow should use after tax discount rate.

Net Present Value Formula

The Net Present Value Formula for a single investment is: NPV = PV less I

Where:

PV = Present Value
I = Investment
NPV = Net Present Value

The Net Present Value Formula for multiple investments is:

The sum of all terms of:

CF (Cash flow)/ (1 + r)t

Where:

CF = A one-time cash flow
r = the Discount Rate
t = the time of the cash flow

Net Present Value Calculation

For a single investment:

$120,000 – $5,000 = $115,000

Where:

PV = $120,000
I = $5,000
NPV = $115,000

For multiple investments:

$120,000 / (1 + 10%)1 = $109,091

Where:

CF = $120,000
r = 10%
t = Year 1
NPV = $109,091

As you calculate your net present value, make sure there aren’t any other “destroyers” that could decrease the value of your company. Download your free “Top 10 Destroyers of Value“.

Net Present Value Advantages

Net present value benefits include the following:

Net Present Value Limitations

Net present value disadvantages include the following:

Net Present Value Example

For example, Jody is the owner of a debt collections firm called Collectco. Jody has been working on his company for several years. As the years have piled up on Jody, so has the urge to retire and live a simpler life. Finally reaching the end of his rope, Jody is ready to move on and spend more time with his children. In order to do this, Jody must sell his company. Adding to this, Jody must first make sure his company is up to date with industry standards. If Jody’s company is not performing to the same efficiency as the industry standard, then he will loose some of it’s value in negotiations with a buyer.

Jody begins by hiring an expert consultant in the industry to conduct an audit on the company. The audit turned out to be much better than Jody expected. But despite this, Jody must update his collections software as it is no longer supported by technical assistance from the creator. Jody performs the net present value calculation to evaluate this investment.

$120,000 – $5,000 = $115,000

Where:

PV = The yearly income of Collectco = $120,000
I = The cost of the new collections software = $5,000
NPV = $115,000

Now, Jody can begin the process of finding a buyer for his company. His consultant, an expert in the business dealings of collections firms, tells him that it is in his best interest to know the Net Present Value of his company before he begins negotiations. So, Jody starts this process by attempting to find the easiest way to perform this calculation. After finding few relevant online results for the search “net present value calculator”, Jody happens to find the NPV formula. Jody then performs the following calculation:

$120,000 / (1 + 10%)1 = $109,091

Where:

CF = Collectco yearly cash flow = $120,000
r = 10%
t = Year 1
NPV = $109,091

With this investment and information, Jody can begin to achieve what he has always dreamed of: a comfortable retirement which allows him to spend time with the people he cares about most. Jody is pleased because all of his efforts are resulting in the life he has worked to gain.

If you’re like Jody and want to find you exit, then download the Top 10 Destroyers of Value to maximize the value of your company. Don’t let the destroyers take money from you!

Net Present Value Method

Strategic CFO Lab Member Extra

Access your Cash Flow Tuneup Execution Plan in SCFO Lab. This tool enables you to quantify the cash unlocked in your company.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Net Present Value Method

Net Present Value Template

An excellent net present value template can be found at the Microsoft Office site here: http://office.microsoft.com/en-us/templates/TC100152681033.aspx

Share this:
9

Capital Structure Management

See Also:
Balance Sheet
Cost of Capital
Capital Asset Pricing Model
Capital Budgeting Methods
Net Present Value Method
Capital Expenditures
Organizational Structure

Capital Structure Management

A company’s capital structure refers to the combination of its various sources of funding. Most companies are funded by a mix of debt and equity, including some short-term debt, some long-term debt, a number of shares of common stock, and perhaps shares of preferred stock.

When determining a company’s cost of capital, weight the costs of each component of the capital structure in relation to the overall total amount. This calculates the company’s weighted average cost of capital (WACC). Then use the weighted average cost of capital to calculate the net present value (NPV) of capital budgeting for corporate projects. A lower WACC will yield a higher NPV, so achieving a lower WACC is always optimal. Refer to overseeing the capital structure as capital structure management.

Capital Structure Strategy

Under stable market conditions, a company can compute its optimal mix of capital. A company’s optimal mix of capital is the combination of sources of capital that yields the lowest weighted average cost of capital.

For example, if a company is financed by a combination of low-cost debt and higher-cost equity, then the optimal mix of capital would be some combination involving less of the higher-cost equity and more of the low-cost debt. In conclusion, you can employ capital structure policy and capital structure strategy to achieve the optimal capital mix.

Capital Structure – Optimal Mix Example

Let’s say, for example, a company could raise between 40% and 60% of its needed funds with debt costing 8%. It could raise up to 10% of its needed funds with preferred stock issuance that costs 7.8%. Then it can raise between 30% and 50% of its funds by issuing common stock equity at 12.33%. What capital structure policy should the company employ to achieve its optimal capital mix?

After analyzing the numbers, and due to certain limitations and restrictions outside the scope of this simple example, the company came up with three choices:

           Debt      Preferred Stock     Common Stock      WACC
Mix 1:      40%            10%                50%         10.145%
Mix 2:      59%            10%                31%          9.322%
Mix 3:      60%            10%                30%         11.679%

As you can see, the company would be better off choosing Mix 2, which has the lowest WACC: 9.322%.

capital structure management

Share this:
3

Capital Budgeting Phases

See Also: Capital Budgeting Methods

Capital Budgeting Phases

The phases of the capital budgeting process include the following:

  • Description of the need or opportunity
  • Identification of alternatives
  • Evaluation of the options and the relevant cash flows of each
  • Selection of best alternative
  • Conducting a post-completion audit of the projects.

Examples

To identify capital projects, refer to functional needs or opportunities. Although many are also identified as a result of risk evaluation or strategic planning. Some typical long-term decisions include whether or not to:

  • Buy new office equipment, cars or trucks
  • Add to or renovate existing facilities, including the purchase of new capital equipment/machinery
  • Expand plant or process operations
  • Invest in facilities for a new product line or to expand services
  • Continue or discontinue an existing product line
  • Replace existing capital equipment/machinery with new equipment/machinery
  • Invest in software to meet technology-based needs or systems designed to help improve process and/or efficiency
  • Invest in R&D or intangible assets
  • Build or expanding a foreign or satellite operation
  • Reorganize assets or services
  • Acquire another company.

Refer to capital investment (expenditure) decisions as capital budgeting decisions. They involve resource allocation, particularly for the production of future goods and services, and the determination of cash out-flows and cash-inflows, which need to be planned and budgeted over a long period of time. Because of the complexity of this accounting issues, get involved yourself right from the beginning. Guide them through the whole process.

Project Evaluation

Develop an objective methodology with the upper management. Then evaluate alternate capital projects on a reasonable basis. Consider both quantitative and qualitative issues and use the whole organization as a resource.

Marketing should provide data on sales trends, new demand and opportunities for new products. Managers at every level should be identifying resources that are available to upper-management that may lead to the use of existing facilities to resolve the need/take advantage of the opportunity. They should also be communicating any needs they/their departments or divisions have that should be part of the capital decision.

Financial analysts should also identify the target cost of capital, the evaluation of startup costs, and the calculation of cash flows for those projects chosen for evaluation purposes. If your financial analysts are absent, then refer to qualified external financial experts. By calculating the appropriate discount rate and calculating conservative cash flows, you are contributing to a critical part of this process. As a result, have an independent accounting firm look at the project/these issues impartially. Estimation bias can be dangerous.

Evaluate (predict) how well each capital asset alternative will do. Then, determine whether the net benefits are consistent with the required capital allocation. When doing this, consider that most firms face the scarcity of resources.

capital budgeting phases

Share this:
0

Capital Budgeting Methods

See Also:
Capital Budgeting Phases
Cost of Capital
Discount Rates NPV
Net Present Value
Cost of Capital Funding

Capital Budgeting Methods Definition

Most small to medium sized companies have no idea how to approach capital investments. They treat it as if it were an operating budget decision rather than a long-term, strategic decision that will impact their cash flow, efficiency of their daily operations, income statement, and taxable income for years to come. They need your help understanding the importance of and then making the right capital budgeting decisions.

Capital budgeting decisions relate to decisions on whether or not a client should invest in a long-term project, capital facilities and/or capital equipment/machinery. Capital budgeting decisions have a major effect on a firm’s operations for years to come, and the smaller a firm is, the greater the potential impact, since the investment being made could represent a substantial percent of the firm’s assets.


Managing capital is one of the many ways that a financial leader can improve profitability. Start developing your financial leadership skills!

Click here to Download the 7 Habits of Highly Effective CFOs


Capital Project Examples

A capital project is usually identified by functional needs or opportunities, although many are also identified as a result of risk evaluation or strategic planning. Some typical long-term decisions include whether or not to:

  • Buy new office equipment, cars or trucks;
  • Add to or renovate existing facilities, including the purchase of new capital equipment/machinery;
  • Expand plant or process operations;
  • Invest in facilities for a new product line or to expand services;
  • Continue or discontinue an existing product line;
  • Replace existing capital equipment/machinery with new equipment/machinery;
  • Invest in software to meet technology-based needs or systems designed to help improve process and/or efficiency;
  • Invest in R&D or intangible assets;
  • Build or expanding a foreign or satellite operation;
  • Reorganize assets or services; or,
  • Acquire another company.

Refer to capital investment (or, expenditure) decisions as capital budgeting decisions. They involve resource allocation, particularly for the production of future goods and services, and the determination of cash out-flows and cash-inflows. Plan and budget the determination of cash out-flows and cash-inflows over a long period of time. Get involved from the beginning. Then, guide them through this process. This is a very complicated accounting issue.

Capital Budgeting Phases

The capital budgeting phases process include:

  • Description of the need or opportunity
  • Identification of alternatives
  • Evaluation of the options and the relevant cash flows of each
  • Selection of best alternative
  • Conducting a post-completion audit of the projects

Identifying Capital Budgeting Needs

The first step is to identify the need or opportunity. Mid-management level employees usually do this. It is the result of a shared vision of company goals and strategies coupled with a “where the rubber meets the road” perspective of “local” clients needs, tastes and behavior. They see a need or opportunity and communicate it to senior management. This is usually done in the form of proposals, which both include:

  • Identification of the need or opportunity
  • Potential solutions and/or recommendations

Senior management evaluates the merit of each proposed opportunity. Then they make a determination of whether or not to look into it further.

While project need identification is usually a decentralized function, capital initiation and allocation decisions tend to remain a highly centralized undertaking. The reason for this revolves around the need for capital rationing. This is particularly true when funds are limited and upper-management wishes to maximize its returns/benefits from any capital project undertaken.

The information needed to make this determination usually comes from both internal and external sources. It is also based on both financial and non-financial considerations. Interestingly enough, the factors examined in this process can be both firm-specific and market-based in nature. Companies should be seeking qualified financial guidance since the consequences of both a poor decision and of the implementation of a good decision can be far-reaching.

Capital Project Evaluation

Have upper management develop an objective methodology so that you can evaluate alternate capital projects on a reasonable basis. Consider both quantitative and qualitative issues and use the whole organization as a resource.

Marketing should provide data on sales trends, new demand and opportunities for new products. Managers at every level should identify resources that are available to upper-management that may lead to the use of existing facilities to resolve the need/take advantage of the opportunity. They should also communicate any needs they/their departments or divisions have that should be part of the capital decision. Involve your financial analysts, or in their absence, qualified external financial experts such as your firm, in the following tasks:

  • Identifying the target cost of capital
  • The evaluation of startup costs
  • The calculation of cash flows for those projects chosen for evaluation purposes

Critical part of this process involve both calculating the appropriate discount rate and calculating conservative cash flows. An independent accounting firm can best look at the project/these issues impartially. Estimation bias can be dangerous.

Evaluate (predict) how well each capital asset alternative will do. Also determine if the net benefits to the firm are consistent with the required capital allocation, given the scarcity of resources most firms face.

(NOTE: Want to take your financial leadership to the next level? Download the 7 Habits of Highly Effective CFO’s. It walks you through steps to accelerate your career in becoming a leader in your company. Get it here!)

Measurements Used in Capital Budgets

The purpose of the evaluation phase is to predict how well a new asset will benefit the firm. Consider the following possible measures, which you should help the firm develop.

Net Income

Managers of net income evaluate the incremental increase in accounting net income between alternatives.

Net Cash Flow

The most widely used measure is net cash flow. This measure looks at the actual cash flows (out and then in) resulting from the capital investment for each alternative. Evaluate these for both overall value (several techniques will be discussed next) and from the standpoint of the effect on daily cash flow and the ability of the firm to meet its financial obligations in a timely manner. Projects with high projected future returns may not be as attractive when adjusted for the time value of money or the costs involved in borrowing funds to meet operating obligations such as payrolls and accounts payable.

Cost Savings

Cost savings are not designed to generate revenues directly. But instead, they are designed to both save costs and increase productivity. Best evaluate these projects on the basis of incremental savings generated.

Cash Flows

Equality of cash flows tend to vary from year to year. The timing of cash flows may be an important consideration to the firm.

Salvage Value

Salvage value and functionality of an existing asset when replacing it with a new asset while the historical cost of an existing asset is not relevant to a capital budgeting decision, the net proceeds from disposal of the existing equipment is. So is the question of how well existing equipment operates given that capital budgeting decisions are only concerned with incremental costs and incremental savings/profits.

Depreciation

Depreciation, earnings and income tax effects need to be considered based on the form of the firm (sole proprietorship, partnership, corporation, etc.). The differences in the financial and tax accounting treatments available to the firm, especially as they apply to salvage value, useful lives and allowed depreciation methods, and, consideration of the marginal tax rate (which may vary from country to country). Most firms fail to consider this cost or choose a tax or financial accounting treatment that does not maximize the firm’s return on invested capital.

Inflation

Inflation the effects of inflation need to be considered in estimating cash flows as well, especially if is projected to increase in future periods and varies between capital projects being considered.

Risk

Risk considerations political risk, monetary risk, access to cash flows, economic stability, and inflation should all be considered in the evaluation process since all are hidden costs in the capital budgeting process.

Interest

Interest and the cost of capital the venture has to have a return that is greater than its cost of capital, adjusted for tax benefits, if any.

Subjective Decisions

The firm should also make a subjective decision as to its preferences in terms of characteristics of projects in addition to the regular selection criteria it has set. For example, does the firm prefer:

  • Projects with small initial investments? Earlier cash flows? Or, perhaps, shorter payback times?
  • New projects or expansion of the existing operations?
  • Domestic projects or foreign operations?
  • If the firm is risk neutral, would the prospects of additional potential cash flows in riskier investments make a capital project more attractive?

Evaluating Risk of Capital Projects

Analyze risk carefully, regardless of which valuation method you used to evaluate the project. The more popular risk-assessment techniques include Sensitivity Analysis, Simple Probability Analysis, Decision-Tree Analysis, Monte Carlo Simulations and Economic Value Added (EVA):

Sensitivity Analysis considers what will happen if key assumptions change. It also identifies the range of change within which the project will remain profitable.

Simple Profitability Analysis assesses risk by calculating an expected value for future cash flows based on their probability of success to future cash flows.

Decision-tree Analysis builds on Simple Profitability Analysis by graphically outlining potential scenarios and then calculating each scenario’s expected profitability based on the project’s cash flow/net income. Managers use this technique to visualize the project and make more informed decisions. Although decision trees can become very complicated, consider all scenarios (e.g., inflation, regulation, interest rates, etc.).

Monte Carlo Simulations use econometric/statistical probability analyses to calculate risk.

EVA, which is growing in popularity, is a performance measure that adjusts residual income for “accounting distortions” that decrease short-term income but have long-term effects on shareholder wealth (e.g., marketing programs and R&D would be capitalized rather than expensed under EVA).

Once you have assessed the risk, which valuation method should the firm/you use for a project? The answer depends on considerations such the nature of the investment (the timing of its cash flows, for instance), uncertainty about the economy and the time value of money if it is a very long term capital project.

Capital Project Evaluation Methods

The four most popular methods are the payback period method, the accounting rate of return method, the net present value method, and the internal rate of return method.

Payback Period Method

This method favors earlier cash flows and selects projects based on the time it takes to recover the firm’s investment. Weaknesses in this method include the facts it does not consider:

  • Cash flows after the payback period
  • The time values of money

Use this method to select from projects with similar rates of return and that were also evaluated using a discounted cash flow (DCF) method. For example, refer to this as the Payback Method based on Discounted Cash Flows or Break-Even Time Method.

Accounting Rate of Return Method

The Accounting Rate of Return (ARR) Method uses accounting income/GAAP information. Calculate it as the average annual income divided by the initial or average investment. Compare the projected return to a target ARR based on the firm’s cost of capital, the company’s past performance and/or the riskiness of the project

Net Present Value Method

Base the Net Present Value (NPV) Method on the time value of money. It is a popular DCF method. The NPV Method discounts future cash flows (both in- and out-flows) using a minimum acceptable cost of capital (usually based on the weighted average cost of capital or WACC, adjusted for perceived risk). Refer to this as the “hurdle rate.” NPV is the difference between the present value of net cash inflows and cash outflows. And a $0 answer implies that the project is profitable and that the firm recovered its cost of capital.

Internal Rate of Return Method

The Internal Rate of Return (IRR) Method is based on the time value of money. It calculates the interest rate that equates the present value of cash outflows and cash inflows. This calculated rate of return is then compared to the required rate of return, or hurdle rate, to determine the viability of the capital projects.

Soft Costs and Benefits in Capital Budgeting Methods

Other considerations the firm/you should consider as part of the valuation process are “soft” costs and benefits. Soft costs and benefits are difficult to quantify by are real non-the-less. Soft costs might be a capital investment in a manufacturing process that results in added pollution to the atmosphere. A soft benefit might be the enhancement of a firm’s overall image as a result of investing in R&D for high-tech products. Ignoring soft benefits and costs can lead to strategic mistakes. This is especially true if you are taking about investments in advanced manufacturing technology. Estimate soft benefits and costs. Then include them as part of the method to determine if a capital project is desirable.

Post Completion Project Evaluation

Once you choose the project and put into operation, a qualified financial services firm, such as yours should undertake a post completion audit of the project. They can evaluate the project objectively. This audit by an independent party will function as a control mechanism to ensure that the capital project is performing as expected. In the event it is not, the audit will make it easier to terminate the project by eliminating any bias of those involved in the project. It will also serve as a learning mechanism for upper management. They will compare actual performance to expected results. In addition, they will improve the processes and estimates they use in future investment decisions.

Control mechanism, which can be expensive, is essential to the success of future capital investment decisions… Especially when considering the long life of most capital projects.

One final word regarding implementation of this control mechanism. Successful post-completion auditing processes require that upper management understand that the purpose of the audit is to learn from past experiences,. Do not penalize managers for the decisions they made. But instead give them the opportunity to learn from them. Learn more of how to becomes a valuable financial leader; download the free 7 Habits of Highly Effective CFOs whitepaper.

capital budgeting methods, capital budgeting, capital project

Strategic CFO Lab Member Extra

Access your Flash Report Execution Plan in SCFO Lab. The step-by-step plan to manage your company before you prepare your financial statements.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

capital budgeting methods, capital budgeting, capital project

Share this:
5

Capital Budgeting Methods

Capital Budgeting Methods

“Most small to medium sized companies have no idea how to approach capital investments. They treat it as if it were an operating budget decision rather than a long-term, strategic decision that will impact their cash flow, efficiency of their daily operations, income statement, and taxable income for years to come. They need your help understanding the importance of and then making the right capital budgeting decisions.

Capital budgeting decisions relate to decisions on whether or not a client should invest in a long-term project, capital facilities and/or capital equipment/machinery. Capital budget decisions have a major effect on a firm’s operations for years to come, and the smaller a firm is, the greater the potential impact, since the investment being made could represent a substantial percent of the firm’s assets….”

More at WikiCFO.com

If you are building a capital budget, then click to access the Budgeting 101 Execution Plan. This execution plan includes principles, rules, and best practices for a successful budget. The SCFO Lab also includes 19+ more execution plans and so much more.

Capital Budgeting Methods

Share this:
0

LEARN THE ART OF THE CFO