In last week's Blog I drew a comparison between the process of triage, which is used in determining the priority of medical treatment for disaster victims, and the process of capital budgeting. My purpose in using triage as a metaphor for capital budgeting was to help build a better understanding of why senior management must employ a triage-like process when allocating the company’s, sometimes limited, resources to fund capital investment proposals. In this revisit to capital budgeting, I’ll be expanding on the “triage” techniques, that are used to identify acceptable capital investment proposals, which are:
Net Present Value - NPV
Profitability Index - PI
Internal Rate of Return - IRR
Net Present Value
The NPV of a capital investment proposal is the difference between the sum of the present values (PVs) of the expected future cash flows from the proposal and the initial investment. Simply stated as:
NPV = Sum of the PVs - Initial Investment
So, if you get a NPV calculation question on the CTP exam, you need to first identify or calculate the PVs of the future cash flows that the capital investment is expected to generate. Next, subtract the initial investment from the total of the PVs. If the result is a positive dollar amount (i.e. NPV > 0), then the proposal is acceptable.
PI is used to prioritize the capital investment proposals that have been determined to be acceptable because they have positive NPVs. PI is calculated as follows:
PI = Sum of the PVs / Initial Investment
If the PI for a given proposal is greater than 1 (i.e. PI > 1) then it is acceptable. As you can see, both the NPV and the PI give you the same answer for a given capital investment relative to its acceptability. That is, if a proposal has a positive NPV then its PI will be greater than 1. The PI answers the question; how much greater?
Internal Rate of Return
The IRR is the discount rate that, when used in the PV calculations of expected future cash flows, drives a proposed capital investments’ NPV to zero. The IRR accomplishes this by aggressively discounting the expected future cash flows until they are reduced to amounts that in total are equal to the initial investment. This can be simply stated as follows:
NPV = Zero when the Sum of the PVs = Initial Investment
For a proposed capital investment to be acceptable, the IRR must be greater than the company WACC (i.e. IRR > WACC)
By thinking about all three of these capital budgeting “triage” techniques as being based on the relationship between the Sum of the PVs and the Initial Investment might help you with exam questions designed to test your understanding of how these techniques are used in the capital budgeting process. .
--George Schilling, CTP