Capital budgeting is an executive decision making technique that all good financial analysts should be familiar with, in order to ensure that their financial modeling and analysis skill set remains relevant and practical to business realities. Capital budgeting is essentially an assessment on whether a capital investment into a project or business asset is worth undertaking from a financial attractiveness perspective.
A good financial analyst should recognize that superior capital budgeting ability is reflected through a sound procedure that evaluates, compares and selects between 2 or more alternatives of an investment / capital expenditure that delivers satisfactory cash flows and rates of return. There are 2 primary capital budgeting metrics that have been traditionally used for this process: the net present value (NPV) and the internal rate of return (IRR), along with a secondary derivative of the IRR – the modified internal rate of return (MIRR).
If 2 or more investments are compared using the NPV method, a discount rate that fairly reflects the risk of each of the investments under consideration should be chosen. It would be realistic for a financial analyst to assess different projects at different discount rates because the risks of each project generally differs. However, a good financial analyst would always keep mind that the result of an NPV based capital budgeting assessment can only be as reliable as the discount rate that is chosen. If the discount rate chosen for the NPV assessment of an investment is unrealistic, the decision to accept or reject the investment would therefore be unreliable.
Like the NPV method to capital budgeting, the IRR method also uses cash flows and recognizes the time value of money. Whilst being easy to compute and understand, the IRR method does have some drawbacks. The main problem with the IRR method is that it often gives unrealistic rates of return.
Assume we are assessing the financial attractiveness of an investment with a hurdle rate of 10% and the IRR is calculated to be 30%. An immediate assumption that financial analysts may infer from the IRR of 30% is that the investment is financially attractive and should be immediately accepted. However this is far from the reality, as an IRR of 30% assumes that there is an opportunity to reinvest future cash flows at 30%, rather than an actual return of 30%.
If proven, historical business performance and general economic conditions indicate that a 30% return is an exceeding high rate for future re-investments, there would be reason for a good financial analyst to suspect that an IRR of 30% is unrealistic. Simply speaking, an IRR of 30% can be considered too good to be true. Hence, unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject an investment.
A good financial analyst should also be aware that the IRR method may entail more problems than a financial modeler may anticipate. Another problem with the IRR method is that the IRR method may give rise to different rates of return. Assume a situation where there are 2 discount rates (i.e. 2 IRRs) that make the present value of an investment equal to the initial investment. In this case, a financial analyst would struggle to choose between the 2 rates as a decision factor for comparison with the cutoff rate.
However, in practice, the IRR method is considered more popular and straightforward than the NPV approach for financial management and decision making, especially for business executives without an advanced level of financial knowledge.
Generally speaking, to balance to trade offs between the NPV method and the IRR method, a good financial modeler would rely on both the NPV and the IRR when performing a capital budgeting assessment. If the IRR results of an assessment returns a very high value, a financial modeler must question whether such an impressive IRR is possible to maintain by looking at past and existing benchmarks, as well as future business opportunities, to see whether an opportunity to reinvest cash flows at such a high IRR really exists. If not, a good financial analyst would reevaluate the financial attractiveness of the investment by the NPV method, using a discount rate that is well researched and proven to be realistic and viable.
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