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Definition and role of capital budgeting
Implementation of a new project is a major capital decision. Therefore, it is important to evaluate such projects before capital is committed. Capital budgeting is a multi-dimensional process with distinctive stages. A commonly used capital budgeting model comprises of strategic planning, making accept or reject decisions, project implementation and monitoring, and project implementation audit. The essence of capital budgeting is to ensure that only viable projects are selected for investment. This is necessary because capital investments require a large amount of initial capital outlay. Thus, companies need to come up with an arrangement on how to raise the capital. Secondly, the streams of benefits received from such investments flow for a long period. Thirdly, capital investment decisions in most cases deal with an organization’s optimal capital structure because the capital needed will be raised through either debt or equity. Also, they are irreversible. Finally, capital is a limited resource. Organizations and even nations lack adequate resources to invest in all viable projects. Thus, it is necessary to appraise all feasible projects and resources should be dedicated to only viable projects (Seitz & Ellison, 2004).
Comparison of articles
Sartoris and Paul (1973) used capital budgeting techniques to evaluate the impact of a lease on the value of a firm (Sartoris & Paul, 1973). In the paper, the authors used net present value criterion to compare the outcome of evaluating lease-or-borrow and lease-or-buy decision. The value of the lease is considered as initial investment. The principal payment of lease is equivalent to depreciation. The authors established that the decision model they used to evaluate the lease were consistent with capital budgeting. In a separate paper done by Cooper, Morgan and Smith (2001), the authors carried out a survey to establish the most commonly used capital budgeting technique (Cooper, Morgan & Smith, 2001). The research was based on fact the use of capital budgeting techniques was gaining popularity at a high rate. In their research, they established that the internal rate of return was the most popular technique. Despite having a number of shortcomings, the payback period was the second most popular technique. The net present value came in third. In a separate research conducted by Brijlal & Quesada (2009), the authors established that payback period was the most popular technique being used across different business despite its numerous drawbacks (Brijlal & Quesada, 2009). The research further established that large companies prefer to use more complicated techniques such as internal rate of return and net present value. However, small businesses used simple methods such as payback period. Therefore, the three articles show that capital budgeting techniques are widely used across the organization. Besides, companies prefer to use simple methods such as payback period because they are easy to apply during the implementation stage of the project (Brijlal & Quesada, 2009).
Selection of a company
In this section, the company that will be analyzed is the Canadian Tire Corporation Limited. The company was established in 1922. It is a public company that trades on the Toronto Stock Exchange with the ticker symbol CTC. The company produces and sells a variety of automotive and home products among others.
Use of capital budgeting techniques
The company is considering the production of resin. The product will be used for wrapping. The management team has come up with two alternatives. These are Epoxy and Synthetic resin. The investment appraisal techniques will be used to evaluate the most viable product to invest in. The company’s cost of capital is estimated at 10%. The table presented below shows a summary of the initial investment and the expected stream of cash flow for the two projects.
Synthetic resin
Epoxy resin
Various investment appraisal techniques will be used to evaluate the two projects and a decision will be made on which project to invest in.
Net present value
Synthetic resin
Epoxy resin
The NPV for Synthetic resin is greater than that of Epoxy. Therefore, Synthetic resin will be selected based on this criterion. The NPV criterion is a suitable way of selecting projects because it takes into account the cash flow for the entire life of the project. Secondly, it makes use of the time value of money. Also, the criterion can be used to estimate the profitability of projects. However, this criterion highly depends on the cost of capital. Also, in some instances, it may conflict with the IRR.
Internal rate of return
Use interpolation to calculate IRR
Synthetic resin
= 20% – [453,575.10 (20% – 45%)] / [453,575.10 – (- 148,111,74)]
= 35.07%
Epoxy resin
= 20% – [328,215.02 (20% – 45%)] / [328,215.02 – ( – 21,105.95)]
=43.49%
Epoxy resin has a higher value of IRR than Synthetic resin. Therefore, it will be the most preferred.
Payback period
Synthetic resin
= 2 years + 250,000 / 500,000
= 2.5 years
Epoxy resin
= 1 year + 200,000 / 400,000
= 1.5 years
Epoxy resin has a shorter payback period than synthetic resin. Therefore, based on this criterion, Epoxy will be selected. However, payback period does not estimate the profitability of projects. Also, it does not make use of the time value of money. Finally, it does not take into account the cash flows after the payback period. Therefore, it is not a suitable method for selecting projects.
Discounted payback period
Synthetic resin
= 2 years + 351,239.67 / 375,657.40
= 2.935 years
Epoxy resin
= 1 year + 254,545.45 / 330,578.51
= 1.77 years
Epoxy resin has a shorter discounted payback period than synthetic resin. Therefore, based on this criterion, Epoxy will be selected.
Profitability index (PI)
Synthetic resin
= (1, 903,021.40 / 1,000,000)
= 1.903
Epoxy resin
= (1,362,214.45 / 800,000)
= 1.703
The profitability index of the two projects was greater than one. This implies that they are viable. However, synthetic resin will be preferred to Epoxy because it has a higher profitability index.
Accounting rate of return (ARR)
Synthetic resin
= (1,600,0000 / 5) / (3,000,000 / 6) * 100
= 64%
Epoxy resin
= (900,0000 / 5) / (2,400,000 / 6) * 100
= 45%
Based on this criterion, Synthetic resin has a higher ARR than Epoxy resin. The analysis above shows that the various techniques yield different results. From the article review above, it was established that IRR and payback period are the most popular techniques. Thus, the two projects will be evaluated using these techniques. From the results above, the company should invest in Epoxy because it has a higher IRR and lower payback period.
References
Brijlal, P., & Quesada, L. (2009). The use of capital budgeting techniques in businesses: A perspective from the Western Cape. The Journal of Applied Business Research, 25(4), 37-46
Cooper, W.D., Morgan, R. G., & Smith, M. (2001). Capital budgeting models: theory vs. practice. Business Forum, 26(1/2), 15-19.
Sartoris, W. L., & Paul, R. S. (1973). Lease evaluation – another capital budgeting decision. Financial Management, 2(2), 46-52.
Seitz, N., & Ellison, M. (2004). Capital budgeting and long-term financing decisions. USA: Thomson Publishers.
Student Self Evaluation
The unit focused on analyzing the key components of capital budgeting process. The course focused on the use of a number of techniques to evaluate long term projects. The instructional methods that were used by the lecturer were effective in delivering the objectives of the course. The methods focused on introducing theoretical concepts, principles and several exercises that relate to investment appraisal. Retaking the course was beneficial to me because it enabled me to have a better understanding of the investment appraisal process and techniques. I have learned that before using an investment appraisal technique, it is important to estimate the net cash flow of a project. Further, I am able to separate the initial investment cost, operating cost, and streams of benefits for a project. With these three items I am able to calculate the net cash flow of a project. Also, I am able to take into account the effect of depreciation, working capital, terminal value, taxation and other important elements when computing the net cash flow.
I have also learned how to use the cost of capital to calculate the discount factor for estimating the future value with present value. Besides, I know how to separate between an annuity and a lump sum. Once I have estimated these values, then I am able to use the various capital budgeting techniques to evaluate the viability of a project or comparing a number of projects. For instance, I can compute the net present value by taking the sum of the present value of the net cash flows. In this case, the initial investment is taken into account. Further, I have learned how to apply the decision criteria for the various appraisal techniques. Therefore, learnings the course was very beneficial to me. I have sharpened my capital budgeting skills and I can be able to evaluate a project using these techniques in real life.
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