In my opinion, the most challenging aspect of capEx process is selection of the proper evaluation criteria & the relevant cut-off values.
A capex project is evaluated on 2 kinds of metrics: Discounted & non-discounted. The non-discounted metrics include Accounting Rate of Return (ARR) & Payback period (PBP). The ARR provides the projected return on average accounting profit as a % of average capital expenditure. The higher the ARR, the more attractive the project. But the challenging question here is, how high is high enough as to justify the project? the ARR should be higher than which cutoff value, to make it acceptable?
PBP gives the time period by when the initial investment will be recouped. The PBP calculated using projected cash flow data are compared with a target PBP & if the computed PBP is less than the cutoff, only then the project is considered viable. Here, too, choice of cutoff is arbitrary & judgmental – the cutoff period chosen can alter the entire decision making, if PBP is considered in isolation.
For both ARR & PBP, a question arises – should the cutoff be based on an existing project’s actual values? Or we need to consider only the specific capex project in hand? While the former has an element of certainty in it & the latter does not, the uniqueness of each project makes a standardization of cutoff values erroneous.
The discounted methods are: NPV, IRR & profitability Index. The NPV gives us the sum of present values of all cash inflows & outflows during project life, discounted at a suitable discount rate. A project is accepted only if NPV > 0. Here, too, there is a choice of discount rate. What should be the discount rate? Existing cost of capital, or the rate of return on past/existing similar projects, or an estimated opportunity cost applicable solely to the new capex project? Choice of the discount rate should substantially affect the NPV & thus, suitability of the project.
IRR is that discount rate which makes NPV equal to 0. The IRR from project should be compared to a cutoff return rate & project is to be accepted only if IRR exceeds this target rate. Question is, what should be the target rate of return? A new project cash flows are based on projections & forecasts can never be perfect. Also, there can be multiple IRRs for a single project, especially when cash flows are non-conventional (occasional cash outflows occur in between cash inflows). In that case, which IRR is valid for comparison purposes?
In reality, all of these metrics are used to evaluate the project. But each metric is based on a number of assumptions & accounting principles. Therefore each metric is highly susceptible to even minor change in the actual values if they deviate from the assumed values, and a seemingly profitable project can turn into a real bad choice, if “things go wrong”.
Hence, in my opinion, selecting the correct project evaluation criteria & formation of these criteria are the most complex, multi-layered & time-consuming task, due to the high level of uncertainty associated with them at each stage.
