The capital budgeting and the weighted average cost of capital (WACC)

Capital budgeting is a methodology used in corporate finance to verify whether a company’s long-term investments, such as new plants, new machinery or new products and / or mergers and acquisitions, are worth the initial cost required.

The primary goal of capital budgeting is creating value for shareholders; to reach this goal we use different methods, such as:

  • Net present value (NPV or NPV in English)
  • Internal rate of return (IRR or IRR in English)
  • Profitability index (Profitability index)

A general feature of these methods is to consider the increase in cash flows generated by each project and to compare it with the cost of the project itself. If the sum of cash flows, appropriately discounted is higher than the initial cost, then the project will create value for investors. Otherwise they project must be discarded.

Classification of projects

In capital budgeting projects are classified as independent or as mutually exclusive.

A project is defined as independent if its cash flows are not conditioned by the acceptance or otherwise of other alternative projects. In this way, all independent projects that meet the criteria should be accepted and carried on.

Projects, on the other hand, define themselves as mutually exclusive if they can not all be accepted at the same time, normally because of budget constrains.

Of all the aforementioned methods, only the net present value and the internal rate of return consider all cash flows and their realization time, but only the net present value (NPV) method always leads to a correct valuation.

This is because it assumes that the cash flows generated are reinvested at the weighted average cost of capital of the company or project, while the internal rate of return method assumes that the flows are reinvested at the same TIR.

Since every project, even within the same company, has a different TIR, the reasoning that implies the VAN is more in line with the company reality

Internal rate of return (TIR)

The internal rate of return is defined in terms of financial mathematics as the rate that makes the net present value equal to zero.

For independent projects and projects that involve a negative initial investment followed by a series of positive cash flows, the use of the internal rate of return leads to the same result as the net present value. In these cases, all projects that have a IRR  higher than the cost of capital should be accepted.

For mutually exclusive projects and / or projects with multiple sign-offs in cash flows instead, the internal rate of return method can lead to selecting a wrong project, ie with a lower NP at the expense of one with higher NPV.

This is because the TIR exists and is unique only in projects with only one inversion of sign in the cash flows, otherwise its curve becomes that of a parabola that intersects the axis of the abscissas in 2 points.

Despite a strong preference for the net present value method in academic circles, the majority of top management still uses the TIR method (source: Melbourne University – 2014 Cost of Capital Survey).

Probably because it is more intuitive to think in terms of return on an investment, comparing it with the cost of capital required.

Sources of financing

Corporate investments can be financed by issuing new shares, issuing bonds and / or hybrid instruments, accessing bank credit or using non-redistributed earnings.

It follows that another objective of capital budgeting and corporate finance is to identify, for each investment, the best sources of financing paying attention to profitability and associated risk.