Capital Budgeting

What is Capital Budgeting?

Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected.

As part of capital budgeting, a company might assess a prospective project’s lifetime cash inflows and outflows to determine whether the potential returns that would be generated meet a sufficient target benchmark. The capital budgeting process is also known as investment appraisal.

Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery.

Corporations are typically required, or at least recommended, to undertake those projects that will increase profitability and thus enhance shareholders’ wealth.

However, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project.

For example, a social or charitable project is often not approved based on the rate of return, but more on the desire of a business to foster goodwill and contribute back to its community.

What Does Capital Budgeting Mean?

Most business’ future goals include expanding their operations. This is difficult to do if the company doesn’t have enough capital or fixed assets. That is where capital budgeting comes into play.

Capital budgets or capital expenditure budgets are a way for a company’s management to plan fixed asset sales and purchases. Usually these budgets help management analyze different long-term strategies that the company can take to achieve its expansion goals. In other words, the management can decide what assets it might need to sell or buy in order to expand the company. To make this decision, management typically uses these three main analyzes in the budgeting process: throughput analysis, discounted cash flows analysis, and payback analysis.

Capital investments are long-term investments in which the assets involved have useful lives of multiple years. For example, constructing a new production facility and investing in machinery and equipment are capital investments. Capital budgeting is a method of estimating the financial viability of a capital investment over the life of the investment.

Unlike some other types of investment analysis, capital budgeting focuses on cash flows rather than profits. Capital budgeting involves identifying the cash in flows and cash out flows rather than accounting revenues and expenses flowing from the investment. For example, non-expense items like debt principal payments are included in capital budgeting because they are cash flow transactions. Conversely, non-cash expenses like depreciation are not included in capital budgeting (except to the extent they impact tax calculations for “after tax” cash flows) because they are not cash transactions. Instead, the cash flow expenditures associated with the actual purchase and/or financing of a capital asset are included in the analysis.

Over the long run, capital budgeting and conventional profit-and-loss analysis will lend to similar net values. However, capital budgeting methods include adjustments for the time value of money. Capital investments create cash flows that are often spread over several years into the future. To accurately assess the value of a capital investment, the timing of the future cash flows are taken into account and converted to the current time period (present value).

Below are the steps involved in capital budgeting.

  1. Identify long-term goals of the individual or business.
  2. Identify potential investment proposals for meeting the long-term goals identified in Step 1.
  3. Estimate and analyze the relevant cash flows of the investment proposal identified in Step 2.
  4. Determine financial feasibility of each of the investment proposals in Step 3 by using the capital budgeting methods outlined below.
  5. Choose the projects to implement from among the investment proposals outlined in Step 4.
  6. Implement the projects chosen in Step 5.
  7. Monitor the projects implemented in Step 6 as to how they meet the capital budgeting projections and make adjustments where needed.

There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the Payback Period, Discounted Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.

Capital Budgeting Methods

There are a number of methods commonly used to evaluate fixed assets under a formal capital budgeting system. The more important ones are noted below.

Net Present Value Analysis

Identify the net change in cash flows associated with a fixed asset purchase, and discount them to their present value. Then compare all proposed projects with positive net present values, and accept those with the highest net present values until funds run out. A concern with using net present value analysis is that the future cash flows associated with a project are uncertain, and are subject to manipulation. The result can be projected cash flows that have been adjusted to ensure that a project will be approved. This issue can only be discovered after the fact, by comparing actual to projected cash flows. Another concern with net present value analysis is that the discount rate used to derive present values can be adjusted downward to ensure that a project is approved; this is usually justified on the grounds that a project is low risk. In short, this supposedly quantitative analysis method is actually subject to qualitative alterations that can significantly impact the decision outcome.

Constraint Analysis

Identify the bottleneck machine or work center in a production environment and invest in those fixed assets that maximize the utilization of the bottleneck operation. Under this approach, a business is less likely to invest in areas downstream from the bottleneck operation (since they are constrained by the bottleneck operation) and more likely to invest upstream from the bottleneck (since additional capacity there makes it easier to keep the bottleneck fully supplied with inventory). This is perhaps the best capital budgeting analysis tool, since it can consistently result in capital investments that improve company profits.

Payback Period

Determine the period required to generate sufficient cash flow from a project to pay for the initial investment in it. This is essentially a risk measure, for the focus is on the period of time that the investment is at risk of not being returned to the company. This analysis is most useful when used as a supplement to the preceding two analysis methods, rather than as the primary basis for deciding whether to make an investment.

Avoidance Analysis

Determine whether increased maintenance can be used to prolong the life of existing assets, rather than investing in replacement assets. This analysis can substantially reduce a company’s total investment in fixed assets. This is an especially useful option when the incremental maintenance expenditure is not significant, such as when there is no need for a major equipment overhaul. However, it may make more sense to upgrade to new equipment when the skills required to maintain the current equipment are so difficult to obtain that the business would be in trouble if its maintenance personnel were to leave the company.

The Importance of Capital Budgeting

The amount of cash involved in a fixed asset investment may be so large that it could lead to the bankruptcy of a firm if the investment fails. Consequently, capital budgeting is a mandatory activity for larger fixed asset proposals. This is less of an issue for smaller investments; in these latter cases, it is better to streamline the capital budgeting process substantially, so that the focus is more on getting the investments made as expeditiously as possible; by doing so, the operations of profit centers are not hindered by the analysis of their fixed asset proposals.

Capital budgeting is important because it creates accountability and measurability. Any business that seeks to invest its resources in a project without understanding the risks and returns involved would be held as irresponsible by its owners or shareholders.

Furthermore, if a business has no way of measuring the effectiveness of its investment decisions, chances are the business would have little chance of surviving in the competitive marketplace.

Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project.

A capital budgeting decision is both a financial commitment and an investment. By taking on a project, the business is making a financial commitment, but it is also investing in its longer-term direction that will likely have an influence on future projects the company considers.

Significance of capital budgeting:

  • Capital budgeting is an essential tool in financial management.
  • Capital budgeting provides a wide scope for financial managers to evaluate
    different projects in terms of their viability to be taken up for investments.
  • It helps in exposing the risk and uncertainty of different projects.
  • It helps in keeping a check on over or under investments.
  • The management is provided with an effective control on cost of capital
    expenditure projects.
  • Ultimately the fate of a business is decided on how optimally the available
    resources are used.

What are the objectives of Capital budgeting?

Capital expenditures are huge and have a long-term effect. Therefore, while performing a capital budgeting analysis an organization must keep the following objectives in mind:

Selecting profitable projects

An organization comes across various profitable projects frequently. But due to capital restrictions, an organization needs to select the right mix of profitable projects that will increase its shareholders’ wealth.

Capital expenditure control

Selecting the most profitable investment is the main objective of capital budgeting. However, controlling capital costs is also an important objective. Forecasting capital expenditure requirements and budgeting for it, and ensuring no investment opportunities are lost is the crux of budgeting.

Finding the right sources for funds

Determining the quantum of funds and the sources for procuring them is another important objective of capital budgeting. Finding the balance between the cost of borrowing and returns on investment is an important goal of Capital Budgeting.

Capital Budgeting Process

Identifying investment opportunities

An organization needs to first identify an investment opportunity. An investment opportunity can be anything from a new business line to product expansion to purchasing a new asset.  For example, a company finds two new products that they can add to their product line.

Evaluating  investment proposals

Once an investment opportunity has been recognized an organization needs to evaluate its options for investment. That is to say, once it is decided that new product/products should be added to the product line, the next step would be deciding on how to acquire these products. There might be multiple ways of acquiring them. Some of these products could be:

  • Manufactured In-house
  • Manufactured by Outsourcing manufacturing  the process, or
  • Purchased from the market

Choosing a profitable investment

Once the investment opportunities are identified and all proposals are evaluated an organization needs to decide the most profitable investment and select it. While selecting a particular project an organization may have to use the technique of capital rationing to rank the projects as per returns and select the best option available. In our example, the company here has to decide what is more profitable for them. Manufacturing or purchasing one or both of the products or scrapping the idea of acquiring both.

Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project. To fund the project it needs to identify the sources of funds and allocate it accordingly.   The sources of these funds could be reserves, investments, loans or any other available channel.

Performance Review

The last step in the process of capital budgeting is reviewing the investment. Initially, the organization had selected a particular investment for a predicted return. So now, they will compare the investments expected performance to the actual performance.

In our example, when the screening for the most profitable investment happened, an expected return would have been worked out. Once the investment is made, the products are released in the market, the profits earned from its sales should be compared to the set expected returns. This will help in the performance review.

FAQ

How does a business determine whether a project (new product or service) is worthwhile?

Projects are accepted or rejected based on the use of one of many capital budgeting models. Using the cash flow of a project and a model such as Net Present Value or Internal rate of Return, the business can determine if the project is worthwhile.

What is the difference between a short-term decision and a long-term decision?

The obvious answer is time frame that the decision affects. In general, short-term decisions have a shorter length of impact, lower cost, and require less information for a decision compared with a long-term decision.

What question is the payback period model answering? What are the two major drawbacks of the payback period? In what situations do businesses still use it?

Payback period answers the question, “how soon will I recover my initial investment (money)?” The two major drawbacks are, it ignores all cash flow after the initial cash flow is recovered and it ignores the time value of money. Many companies use payback for small dollar decisions.

What drawback of discounted payback period does the net present value overcome?

The Net Present Value model overcomes the problem of ignoring all cash flow after the initial cash flow has been recovered. NPV uses all the discounted cash flows of the project.

Why is it straightforward to compare one project’s NPV with that of another project’s NPV? Why does ranking projects based on the greatest to least NPV make sound financial sense?

The final answer for the NPV model is the projects value in current dollars. So we can compare to projects by simply looking at the one with the larger value in current dollars. The greater the NPV of a project the greater the “bag of money” for doing the project so projects can be ranked from most desirable to least desirable.

Why do different projects have different discount rates in the NPV model?

Each project has a different level of risk (based on the riskiness of the future cash flows of the project) so each project in the NPV model should receive an appropriate discount rate that is consistent with the level of risk.

When does the internal rate of return model give an inappropriate decision when comparing two mutually exclusive projects?

With two mutually exclusive projects it is possible to select the one with the lowest netpresent value by selecting the project with the highest IRR. When two projects have fairly different outflows and timing of inflows, their NPV profiles cross-over at some point called the cross-over rate. Below this rate, the project with the lower IRR has the higher NPV and vice-versa. So, selecting the project with the higher IRR would result in accepting a lower NPV, which is sub-optimal.

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