2.26 Summary: Capital Budgeting

Capital budgeting has to do with the allocation of scarce capital resources to the firm’s most profitable potential investment projects. This assumes that corporations are in business to maximize profits and/or cash flows. As a starting point of the analysis, we utilized operating cash flows, which were, presumably, provided ex-ante by an analyst’s projection, a subject, which we covered earlier.

We next compared several capital budgeting techniques, assuming the projections given were certain, an unrealistic assumption indeed. In order of discussion, we looked into:

• Payback
• Discounted Payback
• Net Present Value
• Profitability Index
• Internal Rate of Return
• External or Modified Internal Rate of Return
• Annual Annuity Approach
• Replacement Chain Analysis
• (Market / Economic Value Added)

Numerous faults were cited with each alternative approach, and no method was found to be perfect. In the end, the analyst will have to cope not only with the imperfections of capital budgeting techniques and the uncertainty of projections, but qualitative issues that may impact the data in immeasurable ways. The author, in his experience, has always used both NPV for a dollar value and MIRR for a return figure in his analyses.

We also discovered that it is possible, indeed reasonable, to use more than one discount rate; such rates may be derived from the Spot Curve and, at times, by using Forward Rates.