The material below comprises excerpts from books by Dr. Johnathan Mun, our CEO and founder, such as Readings in Certified Quantitative Risk Management, 3rd Edition, and Quantitative Research Methods Using Risk Simulator and ROV BizStats Software Applying Econometrics, Multivariate Regression, Parametric and Nonparametric Hypothesis Testing, Monte Carlo Risk Simulation, Predictive Modeling, and Optimization, 4th Edition (https://www.amazon.com/author/johnathanmun). All screenshots and analytical models are run using the ROV Risk Simulator and ROV BizStats software applications. Statistical results shown are computed using Risk Simulator or BizStats. Online Training Videos are also available on these topics as well as the Certified in Quantitative Risk Management (CQRM) certification program. All materials are copyrighted as well as patent protected under international law, with all rights reserved.
All companies have projects with differing sizes, investment requirements, returns, risks, strategic, and tactical value. This current book is part of the Applied CQRM series and covers the valuation of said projects or programs using economic and financial analysis methods. Advanced analytical techniques and methodologies are then added into the mix, including running scenario and sensitivity analysis, Monte Carlo risk simulation, predictive forecasting, and portfolio optimization with optimal project selection, subject to risk, budget, schedule, and other constraints.
The Project Economics Analysis Tool (PEAT) software is used to illustrate how various project economics and financial results, including Net Present Value (NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), Profitability Index (PI), Return on Investment (ROI), Payback Period (PP), and Discounted Payback Period (DPP), can be computed.
This chapter describes the main techniques (NPV, IRR, MIRR, PI, ROI, PP, and DPP) that are used in capital budgeting analysis. Each approach provides a different piece of information, so in this age of computers, managers often look at all of them when evaluating projects. However, NPV is the best single measure, and almost all firms now use NPV. The key concepts for the main techniques covered are listed below:
- Capital budgeting is the process of analyzing potential projects. Capital budgeting decisions are probably the most important ones that managers must make. Such decisions include whether a company should replace worn out/damaged equipment or replace or add to existing equipment to reduce cost; undergo expansion; or invest in a new project or equipment. At its most general, the capital budgeting process involves simply choosing the best project from among several alternatives.
- Once a potential capital budgeting project is identified, its evaluation usually requires the determination of project investment cost, project cash flow estimation, riskiness of the project, and cost of capital adjusting for riskiness of the project, as well as a determination of the key economic indicators.
- The payback period is defined as the number of years required to recover a project’s cost. The regular payback period method ignores cash flows beyond the payback period, and it does not consider the time value of money. The payback does, however, provide an indication of a project’s risk and liquidity, because it shows how long the invested capital will be “at risk.”
- The discounted payback method is similar to the regular payback method except that it discounts cash flows at the project’s cost of capital. It considers the time value of money, but it ignores cash flows beyond the payback period.
- The net present value (NPV) method discounts all cash flows at the project’s cost of capital and then sums those cash flows. The project should be accepted if the NPV is positive.
- The internal rate of return (IRR) is defined as the discount rate that forces a project’s NPV to equal zero. The project should be accepted if the IRR is greater than the cost of capital.
- The NPV and IRR methods make the same accept/reject decisions for independent projects, but if projects are mutually exclusive, ranking conflicts can arise. If conflicts arise, the NPV method should be used. The NPV and IRR methods are both superior to the payback method, but NPV is superior to IRR.
- The NPV method assumes that cash flows will be reinvested at the firm’s cost of capital, while the IRR method assumes reinvestment at the project’s IRR. Reinvestment at the cost of capital is a better assumption and is closer to reality.
- The modified IRR (MIRR) method corrects some of the problems with the regular IRR. MIRR involves finding the terminal value (TV) of the cash inflows, compounded at the firm’s cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outflows.
- The profitability index (PI) shows the dollars of present value divided by the initial cost, so this index measures relative profitability.
- Sophisticated managers consider all of the project evaluation measures because each measure provides a useful piece of information.
- Payback measures liquidity, NPV measures direct dollar benefit, IRR measures percentage return with a safety margin built in, MIRR measures a percentage return considering a better reinvestment rate, and PI measures bang for the buck.
- The post-audit is a key element of capital By comparing actual results with predicted results and then determining why differences occurred, decision makers can improve both their operations and their forecasts of projects’ outcomes.
- Small firms tend to use the payback method rather than a discounted cash flow This may be rational because (1) the cost of conducting a Discounted Cash Flow analysis may outweigh the benefits for the project being considered, (2) the firm’s cost of capital cannot be estimated accurately, or (3) the small-business owner may be considering non-monetary goals.
- If mutually exclusive projects have unequal lives, it may be necessary to adjust the analysis to put the projects on an equal-life basis. This can be done using the replacement chain (common life) approach.
- A project’s true value may be greater than the NPV based on its physical life if it can be terminated at the end of its economic life.
- Flotation costs and increased riskiness associated with unusually large expansion programs can cause the marginal cost of capital to rise as the size of the capital budget increases.
- Capital rationing occurs when management places a constraint on the size of the firm’s capital budget during a particular period.