Topic 5

The Basics of Capital Budgeting

Capital budgeting is a method of analyzing and comparing substantial future investments

and expenditures to determine which ones are most worthwhile. In other words, it’s a
process that company management uses to identify what capital projects will create the
biggest return compared with the funds invested in the project. Each project is ranked by
its potential future return, so the company management can choose which one to invest in
first.

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.

Obviously, capital budgeting involves difficult decisions. In most cases buying fixed
assets is expensive and cannot be easily undone. The management has to decide to spend
cash in the bank, take out a loan, or sell existing assets to pay for the new ones. Each one
of these decisions comes with the eternal question: will they receive the proper return on
investment? Because when you think about it, buying new fixed assets is no different
than putting money any other investment. The company is buying equipment hoping that
is will pay off in the future.

That is why many managers used the present value of future cash flows when deciding
what to buy. Present value dollars will help them analyze the current and future cash
inflows and outflows equally to come up with the best plan for the future.
What Are the Objectives of Capital Budgeting?

Capital budgets are the key control documents when it comes to the financial planning for
long-term investments such as major equipment purchases, land purchases, renovations
or new buildings. Capital budgeting identifies how much will be spent for the entire
project, tracking each line item separately. It explains how the business will pay for the
capital project and determines payback time and method.

Determine Product Scope

Capital budgeting lets project planners define the financial scope of a project. Because
capital budgeting begins long before the project begins, it spells out how much money the
business plans to spend on each individual aspect of the project. For example, with a
renovation, it determines how much it is willing to spend on improving handicap
accessibility or installing energy-efficient heating units. Capital budgeting also
determines the scope in terms of the length of time the project will take as it also budgets
for labor and potential downtime.

Determine Funding Sources

While capital budgeting spells out the details of project expenses, it also details where the
money is coming from to pay for the project. These sources might include a capital
investment account, cash, bank loans, government or nonprofit grants or stock offerings.
Most often, a project will require a mix of those funding channels. The capital budgeting
process identifies how much money will be needed from each source and the costs
associated with using that funding method.

Determine Payback Method

An important element of capital budgeting is determining the project's payback time.

Most businesses expect a new building, new equipment or renovation to eventually pay
for itself. Some projects will pay for themselves quicker than others. As there are several
ways of calculating payback method, some involving the present value of money and
inflation, the capital budget will have to identify which method the company plans to use.
It will also include an estimate of how long it will take for the business to realize a return
on their capital investment.
Control Project Costs

Capital budgets act as control documents throughout the life of the project. As the project
progresses, the project managers track costs and try to ensure that the project stays within
budget. When there is an overage or a significant underage, the project managers must
provide explanations for the variances and the business must make sure it has money to
complete the project. Typically a capital budget for a specific project is maintained until
the payback period is complete.

Ongoing Projects

Capital budgets are also used for ongoing capital purchases. These include major repairs,
rolling computer upgrades and preventive maintenance. Because some of these type of
expenses occur on an emergency basis, capital budgeting allows a business to be prepared
in a crisis and not have to incur extra debt. This type of capital budgeting creates a fund
that sets money aside for necessary capital expenses, whether they can be anticipated or
not.

Importance of Capital Budgeting

(a) Long-term Applications

Implies that capital budgeting decisions are helpful for an organization in the long run as
these decisions have a direct impact on the cost structure and future prospects of the
organization. In addition, these decisions affect the organization’s growth rate.

Therefore, an organization needs to be careful while making capital decisions as any

wrong decision can prove to be fatal for the organization. For example, over-investment
in various assets can cause shortage of capital to the organization, whereas insufficient
investments may hamper the growth of the organization.

(b) Competitive Position of an Organization

Refers to the fact that an organization can plan its investment in various fixed assets
through capital budgeting. In addition, capital investment decisions help the organization
to determine its profits in future. All these decisions of the organization have a major
impact on the competitive position of an organization.
(c) Cash Forecasting

Implies that an organization needs a large amount of funds for its investment decisions.
With the help of capital budgeting, an organization is aware of the required amount of
cash, thus, ensures the availability of cash at the right time. This further helps the
organization to achieve its long-term goals without any difficulty.

(d) Maximization of Wealth

Refers to the fact that the long-term investment decisions of an organization helps in
safeguarding the interest of shareholders in the organization. If an organization has
invested in a planned manner, shareholders would also be keen to invest in the
organization. This helps in maximizing the wealth of the organization. Capital budgeting
helps an organization in many ways. Thus, an organization needs to take into
consideration various aspects.

Capital Budgeting Process

A) Project identification and generation

The first step towards capital budgeting is to generate a proposal for investments. There
could be various reasons for taking up investments in a business. It could be addition of a
new product line or expanding the existing one. It could be a proposal to either increase
the production or reduce the costs of outputs.

B) Project Screening and Evaluation

This step mainly involves selecting all correct criteria’s to judge the desirability of a
proposal. This has to match the objective of the firm to maximize its market value. The
tool of time value of money comes handy in this step. Also the estimation of the benefits
and the costs needs to be done. The total cash inflow and outflow along with the
uncertainties and risks associated with the proposal has to be analyzed thoroughly and
appropriate provisioning has to be done for the same.

C) Project Selection

There is no such defined method for the selection of a proposal for investments as
different businesses have different requirements. That is why, the approval of an
investment proposal is done based on the selection criteria and screening process which is
defined for every firm keeping in mind the objectives of the investment being undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring
funds have to be explored by the finance team. This is called preparing the capital budget.
The average cost of funds has to be reduced. A detailed procedure for periodical reports
and tracking the project for the lifetime needs to be streamlined in the initial phase itself.
The final approvals are based on profitability, Economic constituents, viability and
market conditions.

D) Implementation

Money is spent and thus proposal is implemented. The different responsibilities like
implementing the proposals, completion of the project within the requisite time period
and reduction of cost are allotted. The management then takes up the task of monitoring
and containing the implementation of the proposals.

E) Performance review

The final stage of capital budgeting involves comparison of actual results with the
standard ones. The unfavorable results are identified and removing the various difficulties
of the projects helps for future selection and execution of the proposals.

Factors Affecting Capital Budgeting

Availability of Funds Working Capital

Structure of Capital Capital Return

Management decisions Need of the project

Accounting methods Government policy

Taxation policy Earnings

Economic value of the

Lending terms of financial institutions
project

Capital Budgeting Decisions

The crux of capital budgeting is profit maximization. There are two ways to it; either
increase the revenues or reduce the costs. The increase in revenues can be achieved by
expansion of operations by adding a new product line. Reducing costs means
representing obsolete return on assets.

Accept / Reject decision – If a proposal is accepted, the firm invests in it and if rejected
the firm does not invest. Generally, proposals that yield a rate of return greater than a
certain required rate of return or cost of capital are accepted and the others are rejected.
All independent projects are accepted. Independent projects are projects that do not
compete with one another in such a way that acceptance gives a fair possibility of
acceptance of another.

Mutually exclusive project decision – Mutually exclusive projects compete with other
projects in such a way that the acceptance of one will exclude the acceptance of the other
projects. Only one may be chosen. Mutually exclusive investment decisions gain
importance when more than one proposal is acceptable under the accept / reject decision.
The acceptance of the best alternative eliminates the other alternatives.

Capital rationing decision – In a situation where the firm has unlimited funds, capital
budgeting becomes a very simple process. In that, independent investment proposals
yielding a return greater than some predetermined level are accepted. But actual business
has a different picture. They have fixed capital budget with large number of investment
proposals competing for it. Capital rationing refers to the situation where the firm has
more acceptable investments requiring a greater amount of finance than that is available
with the firm. Ranking of the investment project is employed on the basis of some
predetermined criterion such as the rate of return. The project with highest return is
ranked first and the acceptable projects are ranked thereafter.

Similarities between Capital Budgeting and Security Valuation

In both Security Valuation and Capital Budgeting, attempts are made to predict present
value of future returns to assess the value of a project and earnings/dividends to assess
the current price of a security. In security valuation (shares), the current share price is
based on the expected future value of a share plus any dividends in the intervening years,
all brought into the same context by deriving the values at the present time. In security
valuation (bonds), the future return has an impact on the current price. In Capital
Budgeting, future net cash flows over the life of the project are brought into the same
context by deriving the values at the present time, either in absolute or relative terms. In
Security Valuation, the analyst can assess which security prices are under/over-valued
and act accordingly. In Capital Budgeting, the relative performance of alternative projects
are assessed and chosen accordingly.

Therefore, Security Valuation and Capital Budgeting are similar in that they use similar
methodologies to differentiate between the relative merits of identified securities, or
available projects. In both cases, the aim is to maximise the worth/value to the
individual/company over a period of time. For example, if a share is under-valued
relative to expected future earnings, purchase now and sale at a later date should deliver
an increase in net worth. In Security Valuation, the securities should be chosen to deliver
the maximum increase in Net Worth over a fixed time horizon. In Capital Budgeting, the
best combination of projects should be chosen to deliver the maximum return on capital
invested, over a fixed time horizon.

As denoted above, Capital Budgeting has a direct effect on Security Valuation by

prioritising projects that will result in the greatest increase in future earnings/dividends,
increasing the likely dividends or interest payable, and increasing the valuation of the
price of a share. The choice of projects will have an impact on Cash Flow and when
capital is required to fund the investment required. This in turn will also have an impact
on future company value, dependant on how the capital for the projects is financed.

As a company grows and acquires additional assets, the company liquidity position
changes, and the likelihood of future earnings also increases, which should have a
positive impact on share price and security valuation. These additional assets allow the
company to select from a wider range of projects from which to maximise future
wealth. As discussed above, these are Capital Budgeting decisions.

Security Valuation also impacts on the credit rating of a company, which in turn changes
the real return required on projects, and the discount rates which should be applied to the
Net Present Value calculations within Capital Budgeting. For example, if too much
Commercial Paper is issued by a company, this will increase its gearing and financial
risk, and will cause a Credit Rating Downgrade.

Therefore, Security Valuation and Capital Budgeting have similar methodologies and are
closely related.

Capital Budgeting Decision Rules

A Capital Budgeting Decision may be defined as the firm’s decision to invest its current
funds (Cash Flows) most efficiently in the long term assets in anticipation of an expected
flow of benefits over a series of years.

Investment Decisions include:

  Expansion
 Acquisition
 Modernisation
 Replacement
 New Product Investment
 Obligatory & Welfare Investment

It also includes Outflows on Research &Development and major advertising campaign.

Why Cash Flows provide a better estimate of project’s true return

• Accounting profits are the end result of a number of accounting decisions. These
can be manipulated through the use of creative accounting.
• No business accepts profits as payment for goods & services delivered .All of
them require cash. Thus cash flows provide better estimates of a project’s true
return.

Investment Evaluation Criteria

• Estimation of Cash Flows

• Estimation of cost of Capital
• Application of a decision rule for making the choice

Investment Decision Rule

• It should maximize the shareholders’ wealth.

• It should consider all cash flows to determine the true profitability of the project.
• It should provide for an objective and unambiguous way of separating good projects
from bad projects.
• It should help ranking of projects according to their true profitability.
• It should recognize the fact that bigger cash flows are preferable to smaller ones
and early cash flows are preferable to later ones.
• It should help to choose among mutually exclusive projects that project which
maximizes the shareholders’ wealth.
• It should be a criterion which is applicable to any conceivable
investment project independent of others.

Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria

 Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
2. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted payback period (DPB)
Accounting Rate of Return (ARR)

Net Present Value Method

• Cash flows of the investment project should be forecasted based on realistic

assumptions.
• Appropriate discount rate should be identified to discount the forecasted cash flows.
• Present value of cash flows should be calculated using the opportunity cost of capital
as the discount rate.
• Net present value should be found out by subtracting present value of cash outflows
from present value of cash inflows. The project should be accepted if NPV is positive
(i.e., NPV > 0).

The formula for the net present value can be written as follows:

Calculating Net Present Value

Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash
inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The
opportunity cost of the capital may be assumed to be 10 per cent.