Capital budgeting is perhaps the most important decision for a financial manager. Since it involves buying expensive assets for long term use, capital budgeting decisions may have a role to play in the future success of the company. The right decisions made by the process of capital budgeting will help the manager and the company to maximize the shareholder value which is the primary goal of any business.
Capital Budgeting Process
The capital budgeting process includes identifying and then evaluating capital projects for the company. Capital projects are the ones where the cash flows are received by the company over longer periods of time which exceeds a year. Almost all the corporate decisions that impact future earnings of the company can be studied using this framework. This process can be used to examine various decisions like buying a new machine, expanding operations at another geographic location, moving the headquarters or even replacing the old asset. These decisions have the power to impact the future success of the company. This is the reason the capital budgeting process is an invaluable part of any company.
The capital budgeting process has the following four steps:
- Generation of Ideas: The generation of good quality project ideas is the most important capital budgeting step. Ideas can be generated through a number of sources like senior management, employees and functional divisions or even from outside the company.
- Analysis of Proposals: The basis of accepting or rejecting a capital project is the project’s expected cash flows in the future. Hence, all the project proposals are analysed by forecasting their cash flows to determine expected the profitability of each project.
- Creating the Corporate Capital Budget: Once the profitable projects are shortlisted, they are prioritized according to the available company resources, a timing of the cash flows of the project and the overall strategic plan of the company. Some projects may be attractive on their own, but may not be a fit to the overall strategy.
- Monitoring and Post-Audit: A follow up on all decisions is equally important in the capital budgeting process. The analysts compare the actual results of the projects to the projected ones and the project managers are responsible if the projections match or do not match the actual results. A post-audit to recognize systematic errors in the cash flow forecasting process is also essential as the capital budgeting process is as good as the inputs’ estimates into the forecasting model.
Capital Budgeting Process for various Categories of Projects:
Capital budgeting projects are categorized as follows:
- Replacement Projects for Maintaining Business: Such projects are implemented without any detailed analysis. The only issues pertaining to these types of projects are first whether the existing operations continue and, if they do so, whether the existing processes should be changed or maintained as such.
- Replacement Projects for Reducing Cost: Such projects are implemented after a detailed analysis because these determine whether the obsolete, but still operational, equipment should be replaced.
- Expansion Projects: Such projects require a very detailed analysis. These projects are undertaken to expand the business operations and involve a process of making complex decisions as they are based on an accurate forecast of future demand.
- New Product/Market Development: Such projects also consist of making complex decisions that require a detailed analysis as there is a great amount of uncertainty involved.
- Mandatory Projects: Such projects are required by an insurance company or a governmental agency and often involve environmental or safety-related concerns. These projects will not generate any revenue, but they surely accompany new projects started by the company to produce revenue.
- Other Projects: Some projects that cannot be easily analyzed fall into this category. A pet project involving senior management or a high-risk project that cannot be analyzed easily with typical assessment methods are included in such projects.
Principles of Capital Budgeting Process
The capital budgeting process is based on the following five principles:
- All the capital budgeting decisions are based on the incremental cash flows of the project, and not on the accounting income generated by it. Sunk costs are not considered in the analysis. The external factors that can impact the implementation of the project and eventually the cash flow of company has to be fully considered while preparing / planning the capital budgeting.
- All the cash flows of the project should be based on the opportunity costs. Opportunity costs account for the money that the company will lose by implementing the project under analysis. These are the existing cash flows already generated by an asset of the company that will be forgone if the project under analysis is undertaken.
- The timing of the receipt of the cash flows is important. As per the time value of money concept, cash flows of the project received earlier has more value than the cash flows received later.
- All the cash flows from the project should be analyzed on an after-tax basis. The company should evaluate only those cash flows that they will keep, not those that they will pay to the government.
- The financing costs pertaining to a project should not be considered while evaluating incremental cash flows. These costs are already reflected in the project’s required rate of return.
Evaluation and Selection of Capital Projects
All the capital projects are thoroughly analyzed on the basis of their cash flows forecast. However, the evaluation and selection of capital projects are also affected by the following categories:
- Independent versus Mutually Exclusive Projects: Independent projects are unrelated to each other and are thus, evaluated independently based on the individual profitability of each project. For example, assume both projects X and Y are independent and are profitable as well, then there is a probability that the company will accept both the projects. However, mutually exclusive implies that only one of the projects from a set will be accepted and that there is a competition among the projects itself. For example, if projects X and Y are mutually exclusive, the company cannot select both but only either X or Y.
- Project Sequencing: Some projects are implemented in a certain sequence or order so that the investment in one project today generates the opportunity to invest in other future projects. If a project implemented today is profitable, it will create the option to invest in the second project next year. However, if the same current project becomes unprofitable, the company won’t invest in the next project.
- Unlimited Funds versus Capital Rationing: If a company has unlimited funds, it can execute all the projects where expected returns are in excess of the cost of capital. However, many companies have capital constraints and have to use capital rationing. If the company’s profitable projects exceed the funds available for investing, the company resorts to rationing or prioritizing, the capital expenditures. This helps the company to achieve the goal of maximum increase in the shareholders’ value given the available capital.
Conclusion: Capital budgeting process is an amalgamation of very complex decisions and their assessments. A single project can easily harm or enable the company to a large extent. Hence, an analyst needs to understand all the steps involved as well as the basic principles of the capital budgeting process.
References:July 12th, 2017