Question

Referencing textbook readings, lecture material, and current business resources explain key metrics of capital budgeting. Which metric(s) do you find more (less) important? Why?

Also, discuss the difference between leveraged and unleveraged NPV and IRR metrics. What is the purpose of calculating two types of NPV and IRR?

Answer 1

Capital budgeting is a decision making technique of how to allocate scarce resources among various projects and generate the maximum amount of profit or shareholder wealth for the company. The same concepts can be applied in different types of decision making such as working capital, leasing, M&A, security valuation and so on and thus it is an essential concept of financial theory.

There are several methods of Capital budgeting:

A. Net Present Value: Probably one of the most popular and comprehensive technique, wherein we discount the future cash flows from a project to time 0 and then find the difference between the Initial investment and the sum of the PV of the future CFs to see whether the project is worth investing.

r is the discount rate.

Decision rule:

•   Select if NPV > 0
•   Reject if NPV <0

B. Internal Rate of Return: It is the discount rate with makes the NPV of the project = 0 and therefore implies a maximum discount rate of the project beyond which the NPV will be negative and the project will not be worth investing. Simply put, IRR is the return of the project

Decision rule:
•   Select if IRR > required rate
•   Reject if IRR < required rate

This method is not always reliable because when the CF stream is unconventional, then there can be multiple IRRs and when the Inflows are much higher than the outflows, then there might not be any IRR at all.

C. Profitability Index: It is a direct derivation from the NPV method and just another way of representing the same and therefore, this method will always give the same decision as will the NPV method.

Decision rule:
   Select if PI > 1
   Reject if PI < 1

As PI is derived from NPV, it will always suggest the same. PI of A > 1 so it should be selected, that of B is less than 1 so it should not be selected.

D.   Payback period: This is the amount of time it takes to recover the initial investment of the project. This simple method ignores time value of money as it doesn’t use any discount rate in the calculation, which is its advantage and disadvantage at the same time, because although it is simple to calculate, ignoring TVM is not a rational way.

Apart from this there are other flaws of this method too and to avoid the same, there is a modification of this method known as the Discounted Payback Period

In case of a conflicting selection or rejection decision of each of the above methods, always the NPV method decision should be followed. IRR is unreliable when the cash flows are unconventional, i.e. they involve multiple sign changes. Payback period method doesn’t consider the entire life of the project so once the initial outlay is recovered, it ignores the fact that there could be a very high negative CF after wards which might make the project unattractive.

There can be additional criteria for selection of projects such as a maximum acceptable payback period and then the projects not meeting such criteria can also be rejected. Such variation to these methods can be numerous, however, the underlying logic to calculation remains the same.

Levered NPV and IRR method include the change in the debt to calculate the cashflows so the changes in the net borrowings is the difference between the CF of levered and unlevered NPV and IRR. Further the discount rate used in NPV is the WACC or the weighted average cost of capital, which included the cost of debt too.

The purpose of calculating the two types of metrics are

• Assess the benefits of the tax shield of the interest on debt as it is tax deductible.
• Levered measures include operating as well as financial risks of the company which is more realistic if the company has debt in its capital structure.