Using BPC for Capital Budgeting Decisions

Using BPC for Capital Budgeting Decisions

In the business planning arena, SAP BusinessObjects Planning and Consolidation (BPC) is commonly used for regular financial planning activities such as cost center planning, budgeting, revenue planning, income statement planning, cash flow planning, etc. Other common areas of usage for the application include headcount planning and compensation planning. However, the true power of BPC can very well be leveraged to facilitate capital budgeting decisions. This becomes especially advantageous when BPC gets integrated with your Netweaver system and can share the same infrastructure with other Netweaver components. This article will discuss a number of approaches to using BPC for capital budgeting and will also talk about the pros and cons of each approach. Let us begin with defining the meaning of capital budgeting and describing what kind of projects can be classified as capital projects. 

What is Capital Budgeting:

• Definition: The term 'capital' in this context refers to the long term assets used in production and 'budget' signifies the details of future inflows and outflows for some definite future periods. Hence we can say that the term 'capital budgeting' is the process of analyzing projects and making a decision as to which projects to be included in the capital budget.
• Importance: Good capital budgeting is very important for the competitiveness of any company. Erroneous capital budgeting may result in high depreciation expense and eventual drag on the profitability. If sufficient investments are not done, that also may have deleterious effect on the bottom line because it may result in insufficient capacity or adoption of obsolete technology and eventual loss of market share. Moreover, generally capital budgeting involves substantial expenditures and the funds have to be lined up beforehand.

Types of Capital Budgeting Projects:

Generally speaking, there are three types of capital budgeting projects - replacement, expansion and infrastructure.

• Replacement projects are required for maintenance of business (e.g. replace worn out machinery) or for reducing cost (e.g. replace enterprise system with amore efficient system). The replacement projects for cost reduction are generally discretionary projects and require much detailed analysis than the replacements for maintenance purposes.
• The expansion projects are either for expansion of existing products/markets (e.g increase output, increase distribution facilities etc.) or for expansion into new products/markets (e.g expansion into a new country). Expansion projects tend to be more complex than the replacement projects for decision making.
• The third type of capital budgeting projects is infrastructural projects. These include expenditures to comply with regulatory guidelines, safety requirements, and other miscellaneous projects such as new office building, new parking lots etc Making capital budgeting decisions with BPC:

BPC can be used to facilitate capital budgeting decisions using various decision rules. Let us discuss the top 5 decision rules here - viz. Payback, NPV, IRR, MIRR and PI with the pros and cons of each of them. These decision rules can be realized either in one of the existing applications or a in a new application exclusively for capital budgeting. Typical dimensions in that application may include Asset, Asset class, Capaccount, Category, Datasource, Department, Entity, Project, RptCurrency and Time. The advantage of using BPC for capital budgeting is that one can use all the five decision rules if necessary and compare the results and rank the projects judiciously.

• Payback: This is perhaps the most commonly used rule. Payback signifies the expected number of years required to recover the investment. Firms generally use the discounted payback method where the future inflows are discounted using the project's cost of capital. For example, if the initial expenditures for two projects A and B are $10,000 each and if their inflows are as follows:

Let us assume that the project cost of capital is 10%. If these cash flows are existing elsewhere in the appset, we can have a script logic to copy these values to the current application. If these values are not available elsewhere in the appset, we can have a simple input schedule to allow users to maintain projected inflows. Subsequently a script logic or Excel formula can be written to come up with the discounted net cash flow for each project using the project cost of capital. The net cash flow for the above projects looks like the following:

We can see that the project B has a longer payback period than A and hence project A can be ranked higher than B. The advantage of this rule is that it is very easy to determine the liquidity of the projects and can be important if the information of how long the funds are going to be tied up is an important criterion in the decision. This is important to judge the riskiness of the projects. The major disadvantage of this rule is that the cash flows after the payback period are generally ignored.

• NPV: NPV stands for net present value. This involves discounted cash flows of each inflow and outflow, discounted at the project's cost of capital. In the above example, each outflow and inflow can be discounted and summed up to compute the net present value of each project. The project A has a Net Present Value of 788.1975 whereas project B has an NPV of 491.7697. Hence from NPV point of view, project A can be ranked higher than B. This considers all the future cash flows. Since there is a direct correlation between NPV and Economic Value Added (EVA), this method is preferred. Moreover if the project decisions are not mutually exclusive, then this method can help in doing very objective analysis. For example, in the above case, if the NPV for both the projects A and B is negative, then both the projects should be discarded since there won't be any economic value added by undertaking those projects.
  
• IRR: IRR denotes Internal Rate of Return. This is calculated in the similar way as the NPV method above but the only difference is that in NPV, we assume a discount rate and calculate the NPV; whereas in IRR, we assume the NPV and calculate the discount rate. For the purpose of calculating IRR, the NPV is treated as zero. In other words, we find the discount rate for which the NPV is zero. In BPC, we can easily use the Excel formula to calculate IRR for the cash flows copied over from other application or entered by the user in an input schedule as explained above in the discussion of payback rule. In the above example, if we compute the IRRs for the two projects using Excel IRR function, we may get IRRs of 14.5% and 11.8% respectively. If these rates are lower than the hurdle rate or opportunity rate, then these projects are not worthy of further investments. If  both these rates are higher than the opportunity rate, then the project with higher IRR is ranked higher. Though IRR provides a very effective method of calculating the percentage rate (instead of dealing with hard numbers in NPV), this method does not do a good job if the cash flows are not normal. For example, if there is a huge outflow at the end of the project or a big lump sum payment at the beginning of the project etc. This issue arises because this situation results in multiple IRRs for the project and one can not get a clear picture.
  
• Modified IRR: Modified Internal Rate of Return decision rule resolves the above issue. Here instead of equating the cumulative present value of all inflows and outflows to zero to find the rate of return, we equate the present value of all the costs to the future value of all the inflows compounded at the project's cost of capital. If present value (PV) of costs is the net present value of all the all project outflows (negative numbers) and terminal value (TV) is the future value of all the project inflows (positive numbers), then modified internal rate of return (MIRR) is the rate at which PV of costs = PV of Terminal Value. Excel has the MIRR function to compute the modified internal rate of return however many times a custom routine becomes necessary in such complex calculations. In our example above, for projects A and B, the present value of the costs is $10,000. However for the terminal value for project A at 10% discount rate becomes $15,795. Hence the MIRR for project A turns out to be 12.1%. For project B, the terminal value at 10%discount rate becomes $15,361 and the MIRR turns out to be about 11.3%. Please note that MIRR considers that the cash flows from the project are reinvested at some specified rate (generally at the cost of capital) whereas the IRR assumes that the cash flows are reinvested at the project's own IRR, which may not be the case in case of capital projects. In this respect MIRR provides much realistic ranking of the projects than traditional IRR mentioned above.

• Profitability Index: Profitability Index is the ratio of present value of benefits or inflows to the present value of the costs or the outflows. Hence greater than 1.0 PI means that the project is profitable and higher the PI, higher the ranking of the project. In our example above, the present value of benefits for project A is $10,788 and present value of costs is $10,000. Hence PI for project A is 1.0788. Similarly PI for project B is 1.0492.

The unique advantage of using BPC for capital budgeting decisions: As we can see from the foregoing discussion, we can employ all the decision rules for capital budgeting decisions using BPC, making use of the data that we may already have elsewhere in the system. We can also use it plot what is called a net present value profile and compute crossover rate, which we will discuss in a later article. Discounted payback is the easiest way to calculate liquidity of a project but does not consider all the positive cash flows from the project and hence is not good for ranking of the projects. IRR surely provides the safety cushion information that every financial analyst is looking for; but it runs into the multiple IRR issue that we discussed earlier. Though MIRR is better than IRR, it involves a lot complex calculations than IRR. However, NPV is still better than both these since NPV can directly give us the net effect on the economic value itself. With BPC, we are at a unique advantage that we can rank the projects with all these decision rules and BPC can thus be very helpful in giving us a holistic picture of the choices for capital budgeting decision.