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Quick Capital Budget

Annual cash flows can be used to analyze potential investments by companies, known as capital budgeting. Projected cash flows are generated, and then analysis is performed to determine whether a project meets required criteria for approval, and to make a comparison decision between multiple possible projects.

Canada Capital Budgeting Calculator      |       USA Capital Budgeting Calculator       |       WACC Calculator


Canada Capital Budgeting Calculator      |       USA Capital Budgeting Calculator       |       WACC Calculator

Capital Budgeting

Capital Budgeting Calculator

Capital Budgeting Calculations are different in Canada and the US due to differences in the amortization deduction techniques.    In order to help you complete your Capital Budgeting Calculations, we offer three distinct Capital Budgeting Calculators.

 

Quick Capital Budgeting Calculator

Input the annual net cash flows and the required rate of return to quickly complete Capital Budgeting Calculations.

NPV Net Present Value Calculator
IRR Internal Rate of Return Calculator
Profitability Index Calculator
Equivalent Annual Annuity Calculator
Pay Back Period Calculator

 

USA Capital Budgeting Calculator

Input the detailed information, such as incremental costs and revenues, amortization amounts, working capital requirements, project life span, initial outlay and salvage values, and tax rates.

Detailed Capital Budgeting instructions are provided to use the USA Capital Budgeting Calculator on the page.

NPV Net Present Value Calculator
IRR Internal Rate of Return Calculator
Profitability Index Calculator
Equivalent Annual Annuity Calculator
Pay Back Period Calculator

 

Canadian Capital Budgeting Calculator

Input the detailed information, such as incremental costs and revenues, capital cost allowance rate, working capital requirements, project life span, initial outlay and salvage values, and tax rates.

Detailed Capital Budgeting instructions are provided to use the Canadian Capital Budgeting Calculator on the page.

NPV Net Present Value Calculator
IRR Internal Rate of Return Calculator
Profitability Index Calculator
Equivalent Annual Annuity Calculator
Pay Back Period Calculator
Present Value of Tax Shield Calculator

 

What is Capital Budgeting?

Capital Budgeting is a process used to make decisions about capital projects.  Business, individuals and governments need to be able to make rational decisions about whether to engage in a new project, or to decide between multiple projects.

A firm can spend its money in two ways.  They spend money to pay for operational expenses.  They pay labor, inventory and utility expenses in order to continue to operate, so that they can continue to generate profits for shareholders.  A firm can also invest money into capital assets, in order to expand operations. 

Shareholders always have options about where to invest their money, so if the management of a firm decides to retain money in the company to invest in capital assets, shareholders need to be assured that they will be compensated for the use of these funds.  Management needs to limit their investments to capital projects that will generate the most profit possible.

Capital Budgeting is used to decide if a project meets the requirements of management and shareholders before investment begins.  Often a capital investment will require a large initial expenditure, which will then generate revenue for some time in the future.  Capital Budgeting looks at the initial expenditure as well as the expected change in revenues and costs over the life of the project.  Cash flow analysis is then performed to estimate the positive or negative impact that the project will have on the firm, and therefore shareholders.

What is the Capital Budgeting Process?

The Capital Budgeting Process involves many steps, and each one is important to the successful decision making.  The first step in the Capital Budgeting Process is to estimate the project cash flows.  Beginning with the initial expenditure to purchase the capital assets, the Capital Budgeting Project will cause incremental cash flows to the firm.  This means that there will be changes in the cash flows directly attributed to the new Capital Budgeting Project.

Every project is expected to impact revenues and costs.  The incremental change of these cash flows needs to be estimated for the entire life span of the project.  This will generate a series of cash flows covering each year of the project, beginning with the initial purchase of capital assets. 

This series of cash flows needs to include many important components.  The initial outlay will happen at the beginning of the project, but at the end of the project the assets purchased at the beginning may still have some value remaining; this is the salvage value.  This value needs to added to the final cash flow.

There will be a tax benefit to owning the capital asset during the lifespan of the Capital Budgeting Project due to the amortization deduction.  This is called a tax shield, and will positively affect cash flows over the life of the project.  The value of this tax shield can be calculated in different ways, depending on the type of amortization applied.  In Canada, declining balance is used to calculate the tax shield, and so the entire amount can be calculated and discounted so as to be added to the initial cash flow at time zero.  In the USA, declining balance and straight line amortization are used, depending on the asset class, and so the amortization effect should be added to each annual cash flow.

Once a complete estimated series of cash flows has been done, then Capital Budgeting Techniques can be used to analyze the cash flows, and make decisions about the Capital Budgeting Project.

A critical component of Capital Budgeting decision making is the cost of capital.  Cost of capital refers to the cost to the firm for the use of capital from various sources.  The cost of capital is determined by the market value of each of the funding sources of a firm.  Interest rates will influence the cost of the firms borrowed money.  The expected return of shareholders will determine the cost of the equity in the company.  This is critical, since it does not make sense to invest in a project that will return at a rate lower than the cost of the funds required to make the investment.  This would mean investing in a project that is expected to lose money.  Managers would never engage in this activity as they would quickly be replaced by the shareholders.

Once we have and understand the cost of capital, we can use various Capital Budgeting Techniques to compare the costs of capital against the cash flows, in order to make a good decision about the Capital Budgeting Project.

NPV Net Present Value can be used to determine the present value of all the cash flows, discounted at the cost of capital rate.  IRR Internal Rate of Return can be used to understand the rate of return generated by a Capital Budgeting Project.  Payback period is used to quickly estimate the amount of time it will take to return the money invested in the Capital Budgeting Project.  The Profitability Index is used to understand the level of profitability of a project relative to its cost of capital.  The Equivalent Annual Annuity provides the user with an annual payment to be used to compare Capital Budgeting Projects with different life spans.

 

A Capital Budgeting Project

There are basically three types of Capital Budgeting Project: replacement, expansion, and new ventures.  Each of these Capital Budgeting Projects have a different level of risk to a firm.  Since Capital Budgeting involves estimating future revenues and costs, higher levels of uncertainty will increase the risk that the Capital Budget will not be accurate.

Operating firms will already have existing capital projects involved in operations.  These capital assets will eventually need to be replaced, and each time the firm needs to review the options available to it.  Technology, operating requirements, and legislation could have changed, altering the operating characteristics of the capital project.  By analyzing the new Capital Budgeting Project, they can make good decision about how and if they should replace the existing capital assets.

A firm may wish to increase their current activities to a larger scale.  Often this involves purchasing new capital assets, similar to the ones that they already have.  This is expansion, and an important Capital Budgeting Project to help a firm grow. 

Sometimes a firm will engage in new activities, different from what it has done in the past.  This may be due to entering new markets, or changing operations to a new location.  When entering into a new venture, a firm’s ability to accurately estimate future cash flows will be hindered by uncertainty.  This is considered the riskiest capital investment a firm can engage in due to this high level of uncertainty. 

When the risk level of a Capital Budgeting Project increases the rate of return needs to increase along with it.  It does not make sense to engage in a capital project with higher risk when the expected return is equal to a capital project with lower risk.  This means that firms will often restrict their capital investments to their area of expertise unless there is incredible opportunity to benefit from entering into a new venture.

When analyzing a Capital Budgeting Project, it is important to distinguish between stand alone projects and mutually exclusive projects.  When analyzing a standalone Capital Budgeting Project, management is making a decision whether to make the capital investment or not.  We use critical tests to determine if the Capital Budgeting Project will return a sufficient profit to the firm, and therefore its shareholders.  There is often a minimum rate of return that any Capital Budgeting Project must generate in order to be considered worthy of investment.  This rate is often referred to as the hurdle rate.

Sometimes management must decide between multiple Capital Budgeting Projects.  Rather than simply testing whether any one Capital Budgeting Project is good, firms will test several options.  When doing this type of analysis, a firm is deciding which Capital Budgeting Project is the best.  The same tests are used, and often the hurdle rate will still apply as a minimum, but then the decision is to decide which project will return the highest benefit to the firm and its shareholders.

Making decisions between multiple Capital Budgeting Projects can be more complicated, since each Capital Budgeting Project needs to be completed, and then more detailed analysis may need to be done to compare the benefits.  Different projects may have different levels of risk, as well as having different life spans.  The firm may have preferences for early positive cash flows rather than larger cash flows in the future.  It is important to understand what the shareholders expect management to do, and choose the Capital Budgeting Project that best meets this expectation, while still generating the largest possible benefit.

 

NPV Net Present Value

NPV Net Present Value Definition

Net Present Value (NPV) is the present value of all projected cash flows, discounted by the required rate of return of a company.  If the NPV is positive, then the potential project is expected to generate a return higher than the cost of implementation.  NPV is used to compare the expected return of multiple projects, but care must be taken to understand the effect different time horizons may have on the NPV of different projects.

 

NPV Net Present Value Formula

 

NPV Net Present Value Calculation

The NPV Net Present Value Calculation is performed by discounting each annual net cash flow of a project, and then adding all of these discounted amounts together.  If the NPV Net Present Value is positive, then the Capital Budgeting Project is expected to provide a return greater than the required rate of return of the firm, and can be accepted.  The NPV Net Present Value Calculation can be tedious for irregular cash flows with long life spans, and it may be easier to use a NPV Net Present Value Calculator to perform the Calculations for you.

Sensitivity analysis can be used to understand the risks posed by some projects.  A look at the components of the annual cash flows will highlight uncertain values.  These estimated values should be tested to understand the effect that changes will have on the total NPV Net Present Value. 

 

NPV Net Present Value Calculator

The NPV Net Present Value Calculator above will discount each annual cash flow by the required rate of return provided, and sum them to provide the final result.  The NPV Net Present Value Calculator will depend on the values input, and reflect the information provided by the user. 

 

IRR Internal Rate of Return

IRR Internal Rate of Return Definition

Internal Rate of Return (IRR) is used to compare the rates of return generated by cash flows over a period of time.  IRR sets the NPV to 0, and then solves for k, the rate of return.  IRR is used to compare multiple projects, but has some limitations.  It assumes that all positive cash flows can be re-invested at the same rate of return.  This might not be a reasonable assumption if the rate differs from available rates of return available from other projects.  IRR will also produce a false result if there are positive cash flows followed by negative cash flows.

 

IRR Internal Rate of Return Formula

 

IRR Internal Rate of Return Calculation

The IRR Internal Rate of Return Calculation is performed by iteration.  The NPV Net Present Value Calculation is used, and the result is given a value of zero.  The NPV Net Present Value Calculation is then solved for the value k, which is given the term IRR Internal Rate of Return. 

The IRR Internal Rate of Return Calculation is used to understand the rate of return for any individual Capital Budgeting Project.  This IRR Internal Rate of Return can then be used to compare projects.  The higher the IRR Internal Rate of Return, the more favorable the Capital Budgeting Project.

The IRR Internal Rate of Return Calculation has a drawback in that it assumes that all positive free cash flow will be re-invested at the same rate of return.  This might not be a plausible assumption depending on how close the IRR Internal Rate of Return is to typical projects available to a firm.  A highly profitable Capital Budgeting Project might have a high IRR Internal Rate of Return, but there might not be other Capital Budgeting Projects available to re-invest this money in at the same rate.  In these cases the IRR Internal Rate of Return will be overstated.

 

IRR Internal Rate of Return Calculator

The IRR Internal Rate of Return Calculator will use the above formula to solve by iteration.  The result provided will be dependent on the values provided by the user.  It is important to remember the IRR Internal Rate of Return Calculator will assume that cash produced by the Capital Budgeting Project will be re-invested at the IRR Internal Rate of Return.

 

Cash Flow Analysis

The basic concept for Capital Budgeting is to convert a potential business project into a series of cash flows.  This is important as it highlights the importance of cash generation to a business.  All activities in a business should be related or necessary to produce a benefit for the owners of the company.  The main benefit that shareholders look for are business profits.  This is an important concept, because it is independent of the size or growth stage of a company; a small company, a growth company, and a large dividend paying company are all looking to generate profits from their activities and their investments.  The difference between them is what they intend to do with the profits that they generate. 

This means that Capital Budgeting Techniques are used for all companies to make good investment decisions.  The focus of each investment activity is on the positive cash benefit received as a result, and any project that fails to generate the minimum required level of cash will not be pursued.  There are many companies that have made bad investment decisions, and almost every time this is a result poor Capital Budgeting and poor planning. 

The other reason for converting all activities into a series of cash flows is to have a single unit of comparison.  It is difficult to compare the non monetary benefit or cost of projects, but when converted into a series of cash flows, we can use traditional Financial Calculations to compare the cash flows and make a financial decision on a Capital Budgeting Project.

 

Discounted Cash Flows

The Capital Budgeting Process requires that we estimate a cash flow for each year.  We know from the Time Value of Money that there is a cost to money in the future, since we would always rather have an equal amount of money today rather than ten years from now.  For this reason we need to determine the Present Value of Cash Flows that are generated from the Capital Budgeting Project.  In order to Discount Cash Flows we need to understand the value that a firm places on their use of capital.

This means that a firm needs to receive this minimum rate of return in order to be willing to commit its capital.  This is known as the Required Rate of Return.  This is normally equal to the market value of their capital.  We can determine this amount by using the WACC Weighted Average Cost of Capital.  This WACC Weighted Average Cost of Capital is equal to the market value of all of the capital in the firm. 

Now that we have the Required Rate of Return for a firm, we can test any project against this rate.  The Cash Flows from a Capital Budgeting Project are discounted each year by the Required Rate of Return, relative to how many years they are in the future.  This means that the longer a Capital Budgeting Project takes to generate positive cash flows, the larger these cash flows need to be to justify the initial investment.

This can cause problems when estimating long term projects.  A firms WACC Weighted Average Cost of Capital will change over time, and a project that may have been committed when it produced a positive NPV Net Present Value may become more or less profitable in the future as the WACC Weighted Average Cost of Capital changes.  This means that a highly profitable project could become a losing project depending on the sensitivity of cash flows to market prices for capital.

The longer in duration that a Capital Budgeting Project is, the more analysis of risk must be done to understand the possible effects changes could have on the expected outcome.  Sensitivity analysis becomes a critical component of Capital Budgeting.  You can adjust individual values in our Capital Budgeting Calculator to test the effects changes can have to your Capital Budgeting Project.

 

Profitability Index

Profitability Index is a variation of NPV, comparing discounted future cash flows against the initial outlay in the form of a ratio.  This ratio compares the magnitude of the future cash flows against the initial investment required to initiate the project.  This is useful for comparing the profitability of projects of different sizes, where NPV might favor a larger project, but the smaller one might be more profitable.

 

Equivalent Annual Annuity

Equivalent Annual Annuity (EAA) is used to compare projects with different time horizons.  A longer project might produce a higher NPV than a shorter one, simply due to the greater amount of positive cash flow, but not be as profitable as the shorter one.  EAA is used to compare projects with different time horizons on an annual basis, by taking the individual NPV of the project, and determining the equivalent annual annuity payment the project would return over the life of the project.

NPV=Net Present Value of a project
K=Required Rate of Return
N=Number of years of project

 

 

Present Value of Tax Shield

PV of Tax Shield will be added to the cash flow in time period zero as a positive cash flow.  It contains the total present value of the tax shield provided by the amortization of the asset, less the discounted loss of the tax shield from the eventual disposal of the asset.   The formula and variables are as follows.

C=Cost of new asset less proceeds from disposal of previous asset
D=CCA Rate
T=Tax Rate
K=Discount Rate
S=Salvage Value
N=Number of Years until asset is sold

If Asset is to be replaced at the end of this project:

If Asset is not to be replaced at the end of this project:

 




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