The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects where the cash How to the firm will be received over a period longer than a year. Any corporate decisions with an impact on future earnings can be examined using this framework. Decisions about whether to buy a new machine, expand business in another geographic area, move the corporate headquarters to Cleveland, or replace a delivery truck, to name a few, can be examined using a capital budgeting analysis.
For a number of good reasons, capital budgeting may be the most important responsibility that a financial manager has. First, because a capital budgeting decision often involves the purchase of costly long-term assets with lives of many years, the decisions made may determine the future success of the firm. Second, the principles underlying the capital budgeting process also apply to other corporate decisions, such as working capital management and making strategic mergers and acquisitions. Finally, making good capital budgeting decisions is consistent with management’s primary goal of maximizing shareholder value.
The capital budgeting process has four administrative steps:
1. Idea generation. The most important step in the capital budgeting process is generating good project ideas. Ideas can come from a number of sources
including senior management, functional divisions, employees, or sources outside the company.
2. Analyzing project proposals. Because the decision to accept or reject a capital project is based on the project’s expected future cash flows, a cash flow forecast must be made for each product to determine its expected profitability.
3. Create the firm-wide capital budget. Firms must prioritize profitable projects according to the timing of the project’s cash flows , available company resources, and the company’s overall strategic plan. Many projects that are attractive individually may not make sense strategically.
4. Monitoring decisions and conducting a post-audit. It is important to follow up on all capital budgeting decisions. An analyst should compare the actual results to the projected results, and project managers should explain why projections did or did not match actual performance. Because the capital budgeting process is only as good as the estimates of the inputs into the model used to forecast cash flows, a post-audit should be used to identify systematic errors in the forecasting process and improve company operations.
Categories of Capital Budgeting Projects
Capital budgeting projects may be divided into the following categories:
1. Replacement projects to maintain the business are normally made without detailed analysis. The only issues are whether the existing operations should continue and, if so, whether existing procedures or processes should be maintained.
2. Replacement projects for cost reduction determine whether equipment that is obsolete, but still usable, should be replaced. A fairly detailed analysis is necessary in this case.
3. Expansion projects are taken on to grow the business and involve a complex decision-making process because they require an explicit forecast of future demand. A very detailed analysis is required.
4. New product or market development also entails a complex decision-making process that will require a detailed analysis due to the large amount of uncertainty involved.
5. Mandatory projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. These projects typically generate little to no revenue, but they accompany new revenue producing projects undertaken by the company.
6. Other projects. Some projects are not easily analyzed through the capital budgeting process. Such projects may include a pet project of senior management (e.g., corporate perks) or a high-risk endeavor that is difficult to analyze with typical capital budgeting assessment methods (e.g., research and development projects) .
Basic Principles of Capital Budgeting
The capital budgeting process involves five key principles:
1. Decisions are based on cash flows, not accounting income. The relevant cash flows to consider as part of the capital budgeting process are incremental cash flows, the changes in cash flows that will occur if the project is undertaken.
Sunk costs are costs that cannot be avoided, even if the project is not undertaken. Because these costs are not affected by the accept/reject decision, they should not be included in the analysis. An example of a sunk cost is a consulting fee paid to a marketing research firm to estimate demand for a new product prior to a decision on the project.
Externalities are the effects the acceptance of a project may have on other firm cash flows. The primary one is a negative externality called cannibalization, which occurs when a new project takes sales from an existing product. When considering externalities, the full implication of the new project (loss in sales of existing products) should be taken into account. An example of cannibalization is when a soft drink company introduces a diet version of an existing beverage. The analyst should subtract the lost sales of the existing beverage from the expected new sales of the diet version when estimated incremental project cash flows. A positive externality exists when doing the project would have a positive effect on sales of a firm’s other product lines.
A project has a conventional cash flow pattern if the sign on the cash flows changes only once, with one or more cash outflows followed by one or more cash inflows. An unconventional cash flow pattern has more than one sign change. For example, a project might have an initial investment outflow, a series of cash inflows, and a cash outflow for asset retirement costs at the end of the project’s life.
2. Cash flows are based on opportunity costs. Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. These are cash flows generated by an asset the firm already owns that would be forgone if the project under consideration is undertaken. Opportunity costs should be included in project costs. For example, when building a plant, even if the firm already owns the land, the cost of the land should be charged to the project because it could be sold if not used.
3. The timing of cash flows is important. Capital budgeting decisions account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be received later.
4. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing all capital budgeting projects. Firm value is based on cash flows they get to keep, not those they send to the government.
5. Financing costs are reflected in the project’s required rate of return. Do not consider financing costs specific to the project when estimating incremental cash flows. The discount rate used in the capital budgeting analysis takes account of the firm’s cost of capital. Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm.
Factors that impact evaluation and selection of projects
Independent vs. Mutually Exclusive Projects
Independent projects are projects that are unrelated to each other and allow for each project to be evaluated based on its own profitability. For example, if projects A and B are independent, and both projects are profitable, then the firm could accept both projects. Mutually exclusive means that only one project in a set of possible projects can be accepted and that the projects compete with each other. If projects A and B were mutually exclusive, the firm could accept either Project A or Project B , but not both. A capital budgeting decision between two different stamping machines with different costs and output would be an example of choosing between two mutually exclusive projects.
Some projects must be undertaken in a certain order, or sequence, so that investing in a project today creates the opportunity to invest in other projects in the future. For example, if a project undertaken today is profitable, that may create the opportunity to invest in a second project a year from now. However, if the project undertaken today turns out to be unprofitable, the firm will not invest in the second project.
Unlimited Funds vs. Capital Rationing
If a firm has unlimited access to capital, the firm can undertake all projects with expected returns that exceed the cost of capital. Many firms have constraints on the amount of capital they can raise and must use capital rationing. If a firm’s profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize, its capital expenditures with the goal of achieving the maximum increase in value for shareholders given its available capital.