Capital Budgeting in Financial Modeling

<a href="https://doi.org/10.52340/ekonomisti.2025.02.03">10.52340/ekonomisti.2025.02.03</a> Annotation:The paper discusses the company`s financial budgeting process and methods for evaluating investment projects. The paper provides an analysis of their strengths and weaknesses and identifies ways to overcome these weaknesses. The paper also develops an investment project evaluation model and a computer program for use this model in practice. This tool was used to perform sensitivity analysis and show results of analysis graphically. Keywords: Capital budgeting, Payback Period, Net Present Value (NPV), Internal Rate of Return (IRRI), Modified Internal Rate of Return, Profitability Index (PI), and Hurdle Rate of Return. Introduction Capital budgeting is one of the pivotal tools that evaluate the returns expected from investments projects[1,2]. Using these tools, a company assesses the risks and returns properly and make informed decisions to achieve its objectives. The most firms employ several types of capital – capital components: debt, preferred stock, and common stock. In this case, cost of capital should be weighted average cost of capital, or shortly – WACC, which is one of the most important components of the capital budgeting model, and the calculation of which is based on the weights determined by the target capital structure of the company[6]. The target capital structure describes the mix of debt, preferred stock, and common equity expected to optimize a company’s price. As a company raises new capital, it will focus on maintaining this target or optimal capital structure - the perfect balance between maximising the wealth and worth of the company and minimising its cost of capital. Due to debt cost tax deductibility, debt financing offers the lowest cost of capital. However, too much debt increases the financial risk to shareholders and the <a href="https://www.investopedia.com/terms/r/returnonequity.asp">return on equity</a> that they require. Because of that, companies are trying to have the optimal point at which the marginal benefit of debt equals the marginal cost. Capital budgeting decisions include: 1) decisions on a product, service, facility, or activity; 2) sound estimates of the timing and amount of cash flow for the proposal; 3) a predetermined criterion for making or rejecting a decision. Companies with consistent, stable cash flows can tolerate a much larger debt load and will have a much higher percentage of debt in their optimal capital structure. Conversely, a company with volatile cash flows will have little debt and a large amount of equity. It is difficult to pinpoint the optimal capital structure; therefore, managers have to make decisions within a certain range[6,7]. The task of selecting the optimal capital structure is also complicated by the fact that a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm`s stage of development, and can also vary over time due to external changes in interest rates and regulatory environment. There are two types of factors effected on cost of capital. One is that which the firm can control, and another – cannot. Capital structure policy, dividend policy and investment policy are instruments effecting on capital cost, and the interest rate, market risk premium and tax rates are outside internal control. The company`s goal should be to be as close as possible to the optimal capital budget point, where marginal cost of capital (MCC) equals the incremental expected return. The Figure 1 shows the marginal cost of capital and investment opportunity schedule. The MCC of a company tends to increase as it raises additional capital. As the company makes additional investments with this new capital, returns on its investments will generally decrease as represented by the investment opportunity schedule (IOS). The relationship between the MCC and the IOS gives an overview of the basic decision-making problem that a company has. Businesses could pursue projects and opportunities that might enhance shareholder value and profit. Because business has available the amount of capital for new projects is limited, management intensively uses <a href="https://www.investopedia.com/terms/r/replacement-chain-method.asp">capital budgeting techniques</a>. <img src="http://ekonomisti.tsu.ge/img/lemon1.jpg" alt="" width="512" height="168" /> Figure 1 There are a number of <a href="https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp">capital budgeting methods</a>. Among them, the most commonly used are: payback period, discounted payback period, net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), and profitability index[3]. Payback Period The payback period is a financial analytical tool that defines the length of time necessary to earn back money that has been invested. Calculating the payback period can give an investor some insight into the degree of riskiness that the investment represents. The payback periods of two investment projects are outlined in Table 1. <img src="http://ekonomisti.tsu.ge/img/lemon2.jpg" alt="" width="390" height="168" /> Each project requires an initial $1,000 investment. But each project varies in payback periods and number of cash ﬂows generated. Which project is the best? Project (A) and (B) have consistently 4 and 3.33 years, but project (A) generates $500 more cash than project (B). The Payback Period method is most useful for comparing projects with nearly equal lives, or for companies that focus on smaller investments, mainly because smaller investments usually don’t involve overly complex calculations. The payback period shows us how long it takes for the return on investment, but it does not show what is the amount of investment’s return, and: it doesn’t accounting for the time value of money, risk factors, financing concerns or the opportunity cost of an investment. For this reason, payback periods calculated for longer-term investments have a greater potential for inaccuracy. Therefore, using the payback period in combination with other capital budgeting methods is far more reliable. Discounted Payback Period The discounted payback period is a modified version of the payback period. It is similar to the regular payback period except that the expected cash flows are discounted and take account for the time value of money. In this metric, future cash flows are estimated and adjusted for the project’s cost of capital. There are two steps involved in calculating the discounted payback period. First, we must discount the net cash flows that will occur during each year of the project; and, second, to obtain the discounted payback period, we must subtract the <a href="https://corporatefinanceinstitute.com/resources/valuation/dcf-formula-guide/">discounted cash flows</a> from the initial cost figure - this continues until the initial cost figure becomes zero. Table 2 shows one example of discount payback period calculation. <img src="http://ekonomisti.tsu.ge/img/lemon3.jpg" alt="" width="432" height="197" /> In this case, the project’s payback period is 5.16 years (5+ 651/4000= 5 + 0.16 = 5.16). One common disadvantage of both the payback period and discounted payback methods is that it that they ignore the cash flows after the payback period which are serious deficiencies. Net Present Value (NPV) Net present value takes into consideration all the inflows, outflows, period of time, and risk involved.This method compares the present value of a project’s cash inflow to the present value of its outflows. <a href="https://www.investopedia.com/terms/d/discounting.asp">Discounting</a> the after-tax cash flows by the weighted average cost of capital or hurdle rate of return allows us to determine whether a project will be profitable or not. It also determines how profitable a project will be in comparison with alternatives. In common, Positive NPV should results in positive economic value added (EVA) and positive market value added (MVA). According to NPV rule: all projects with a positive net present value should be accepted, and those that are negative should be rejected. A positive (negative) net present value means that the rate of return on the capital investment is greater (less) than the discount rate used in the analysis. In the case when funds are limited, only projects with the highest discounted value should be accepted. In the case of incompatible projects, as shown in Fig. 2, if the cost of capital is less than 6%, NPVA exceeds NPVB and project A will be chosen, and if it is higher than 6%, then project B will be chosen. <img src="http://ekonomisti.tsu.ge/img/lemon4.jpg" alt="" width="530" height="279" /> Figure 2 The NPV outcome heavily depend on inputs, estimates, and long-term projections of cash flows. Among them is discount rate which reflects the opportunity cost of capital and the associated with the investment. The weighted average cost of capital (WACC), industry benchmarks, or the required rate of return for similar investments can be considered as a discount rate. A higher discount rate will reduce the present value of future cash flows, potentially leading to a lower NPV, while a lower discount rate will have the opposite effect. Therefore, careful consideration should be given to the selection of the discount rate based on the specific context of the investment. NPV is important metrics of an investment project as it gives money measure of benefit of the project to shareholders. NPV can be used to compare a projected rate of return with the <a href="https://www.investopedia.com/terms/h/hurdlerate.asp">hurdle rate</a> required to approve an investment. The discount rate in the NPV formula is a hurdle rate for a project based on a company’s cost of capital, such as the weighted average cost of capital (WACC), and a negative NPV shows that the expected rate of return will fall short of it, meaning that the project will not create value. Considering the fact that many businesses have a fixed budget and sometimes have two or more project options, NPV cannot be used for comparing the projects different in period of time; it doesn’t consider project size or return on investment (ROI<a title="" href="file:///C:/Users/zurabi/Downloads/27-06-2025_20-30-08/%E1%83%9A%E1%83%94%E1%83%9B%E1%83%9D%E1%83%9C%20%E1%83%AF%E1%83%90%E1%83%95%E1%83%90%20+.docx#_ftn1">[1]</a>). It also relies heavily on inputs, estimates, and long-term projections, which can have a significant impact on the outcome of a particular project’s valuation. Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is the discount rate that makes the <a href="https://corporatefinanceinstitute.com/resources/valuation/net-present-value-npv/">net present value (NPV)</a> of a project zero. The IRR formula is as follows: <img src="http://ekonomisti.tsu.ge/img/lemon5.jpg" alt="" width="184" height="53" /> Unlike net present value, the internal rate of return doesn’t give you the return on the initial investment in terms of real dollars. Using IRR exclusively can lead you to make poor investment decisions, especially if comparing two projects with different durations. According with NPV, proposed projects are usually accepted if they have a net positive value. In contrast, IRR is often accepted if the resulting IRR has a higher value compared to the existing cutoff rate or hurdle rate. Projects with a positive net present value also show a higher internal rate of return greater than the base value. Let’s consider a company which hurdle rate is 12%, and one-year project A has an IRR of 25%, whereas five-year project B has an IRR of 15% (Table 3). If the decision is solely based on IRR, this will lead to unwisely choosing project A over B, while its NPV is 3.5 times higher than project A`s NPV. <img src="http://ekonomisti.tsu.ge/img/lemon6.jpg" alt="" width="279" height="177" /> Let`s look at Fig. 1 again. If the cost of capital exceeds 6%, both methods will favor project B. A conflicting situation will arise if the cost of capital is less than 6%, because in this case, the NPV choice favors project A, and with IRR, the choice will be project B, this is when net present value of project B is less than the net value of project A, which would not be correct. Another reason why NPV and IRR give different results in comparing mutually exclusive projects is that the first one considers the cost of capital as the reinvestment rate, and the second one - the IRR rate, which is less realistic. Accordingly, the NPV method is more reliable than IRR. Using IRR exclusively can lead an investor to make poor investment decisions, especially if comparing two projects with different durations. Another very important point about the internal rate of return is that it assumes all positive cash flows of a project will be reinvested at the rate as the project of the <a cost of capital. the internal rate of return not the profitability and cost of a In the case when the of the projects is the use of IRR can lead to an which is from the projects considered in Table In if the projects are then NPV and IRR give the but if they are mutually exclusive projects and, they are by different and then NPV should be used as project <p style="text-align: Modified Internal Rate of Return <p style="text-align: we IRR assumes that all cash flows from an investment are reinvested at the IRR rate. 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Authors

Givi Lemonjava

Institutions

Tbilisi State University (GE)

Publication Details

Journal: EKONOMISTI
Published: 2025-06-29
DOI: https://doi.org/10.52340/ekonomisti.2025.02.03
Primary Topic: Capital Investment and Risk Analysis
Type: article
Field-Weighted Citation Impact: 0.00

Capital Budgeting in Financial Modeling

Authors

Institutions

Publication Details

Capital Budgeting in Financial Modeling

Capital Budgeting in Financial Modeling

Abstract

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