Capital Budgeting Basics

Capital budgeting is the whole process of analyzing projects and deciding which ones to accept and thus include in the capital budget. Capital budgeting is key to the long term success of business and companies. A firm’s growth, and even its ability to remain competitive and to survive, depends on a constant flow of ideas for new products, improvements in existing products, and ways to operate more efficiently. Accordingly, well-managed firms go to great lengths to develop good capital budgeting proposals.

Capital Budgeting Overview

Capital budgeting is based on the same procedures that are used in security valuation, but with two major differences. First, stocks and bonds exist in the securities markets and investors choose from the available set. However, firms actually create capital budgeting projects, so capital budgeting involves project creation. Second, most investors have no influence over the cash flows produced by their investments, whereas corporations do have a major influence on their projects’ results. If companies execute their plans well, then capital budgeting projects will be successful, but poor execution will lead to project failures. Still, in both security analysis and capital budgeting, we forecast a set of cash flows, find the present value of those flows, and then make the investment if and only if the PV of the future expected cash flows exceeds the investment’s cost.

Capital Budgeting Types

Analyzing capital expenditure proposals is not costless—benefits can be gained, but analysis does have a cost. For certain types of projects, an extremely detailed analysis may be warranted, whereas simpler procedures are adequate for other projects.

Replacement needed to continue profitable operations. An example would be an essential pump on a profitable offshore oil platform. The platform manager could make this investment without an elaborate review process.

Replacement to reduce costs. An example would be the replacement of serviceable but obsolete equipment in order to lower costs. A fairly detailed analysis would be needed, with more detail required for larger expenditures.

Expansion of existing products or markets. These decisions require a forecast of growth in demand, so a more detailed analysis is required. Go/no-go decisions are generally made at a higher level than are replacement decisions.

Expansion into new products or markets. These investments involve strategic decisions that could change the fundamental nature of the business. A detailed analysis is required, and the final decision is made by top officers, possibly with board approval. 5. Contraction decisions. Especially during bad recessions, companies often find themselves with more capacity than they are likely to need in the foreseeable future. Then, rather than continue to operate plants at, say, 50% of capacity and incur losses as a result of excessive fixed costs, they decide to downsize. That generally requires payments to laid off workers and additional costs for shutting down selected operations. These decisions are made at the board level.

Mergers. Buying a whole firm (or division) is different from buying a machine or building a new plant. Still, basic capital budgeting procedures are used when making merger decisions.

Capital Budgeting  Methods

There are 3 basic capital budgeting methods: Net Present Value (NPV), Internal Rate of Return (IRR), Payback.

The net present value (NPV), defined as the present value of a project’s cash inflows minus the present value of its costs, tells us how much the project contributes to shareholder wealth—the larger the NPV, the more value the project adds and thus the higher the stock’s price. NPV is generally regarded as the best single screening criterion in choosing projects.

A project’s IRR is the discount rate that forces the PV of the inflows to equal the initial cost . This is equivalent to forcing the NPV to equal zero. The IRR is an estimate of the project’s rate of return. Why is the discount rate that causes a project’s NPV to equal zero so special? The reason is that the IRR is an estimate of the project’s rate of return. If this return exceeds the cost of the funds used to finance the project, then the difference is a bonus that goes to the firm’s stockholders and causes the stock’s price to rise.

NPV and IRR are the most commonly used methods today, but historically the first selection criterion was the payback period, defined as the number of years required to recover the funds invested in a project from its operating cash flows. Although the payback methods have faults as ranking criteria, they do provide information about liquidity and risk. The shorter the payback, other things held constant, the greater the project’s liquidity. This factor is often important for smaller firms that don’t have ready access to the capital markets.