Why is capital budgeting such an important process?

Why is capital budgeting such an important process? Why are capital budgeting errors so costly? Differentiate between NPV, PI, and IRR methods. What are the advantages and disadvantages of using each of these methods? Why is there a focus on cash flows rather than accounting profits in making capital-budgeting decisions? Why such an interest in incremental cash flows rather than total cash flows?

When a company is deciding on an investment path, evaluating a capital budget is very important. It is a key component that is used to assess an investment’s ability to return a profit based on fixed assets. This is important because the amount of money involved is usually a substantial amount, and, if the company did not research the investment properly, a failed investment could cost the company a tremendous amount of money that could have been invested in a different project.

 

There are a couple of accounting equations that are used to help companies make these financial decisions. Net present value (NPV) assess an investment’s future free cash flow after the initial investment’s outlay has been deducted. In other words, it assesses the potential net profitability of the investment. As long as the NPV is greater than 0, the investment should turn a profit. Additionally, companies can look at an investment’s profitability index (PI). This is a ratio involving the present value of future free cash flows and the initial outlay. When this ratio is greater than 1, the investment should turn a profit. Lastly, companies should consider the internal rate of return (IRR). This is the rate that the company is expecting to earn on its investment. It takes into account an investment’s annual free cash flow over the project’s expected life and the initial cash outlay. If this rate is greater than the company’s required rate of return, then the company should invest in the project.

 

However, there are some advantages and disadvantages to using these equations to evaluate an investment that should be considered. There advantages include using free cash flows in their assessment, taking into account the time value of money, and they are aligned with the company’s goal of maximizing shareholder wealth. Some disadvantages associated with these equations includes their reliance on a detailed account of the investment’s cash flows and, in the case of the IRR, the assumption that any cash flow earned can be reinvested again at the IRR and the possibility of multiple IRRs.

 

Also, an important detail in the assessment of an investment, is the use of cash flows in the equations. Evaluating an investment using free cash flows allows for an accurate representation of when cash flows into and out of the company. This is more effective than using accounting profits, because accounting profits relies on when cash is earned, and the timing between the two may be different. This timing would have an effect on reinvestment of any cash. If companies used the accounting profits, the company could receive cash it could reinvest, however, if the company has not earned it yet, it wouldn’t be recognized until a later date.

 

Another important detail that should be accounted for when assessing an investment is the incremental cash flow. That is, the amount of cash inflows a company receives from an investment that it can reinvest. This is important to the company so it knows how much money can be reinvested into a project.