Capital budgeting is a complex process that involves careful analysis and calculation especially for large projects. There are some basic principles you need to take into consideration when performing capital budgeting.
Capital Budgeting Principle
There are several key principles you need to follow:
Decisions are based on cash flows. The decisions are not based on accounting concepts, such as net income. Furthermore, intangible costs and benefits are often ignored because, if they are real, they should result in cash flows at some other time.
Timing of cash flows is crucial. Analysts make an extraordinary effort to detail precisely when cash flows occur. Cash flows are based on opportunity costs. What are the incremental cash flows that occur with an investment compared to what they would have been without the investment?
Cash flows are analyzed on an after-tax basis. Taxes must be fully reflected in all capital budgeting decisions.
Financing costs are ignored. This may be unrealistic. but it is not. Most of the time, analysts want to know the after-tax operating cash flows that result from a capital investment. Then, these after-tax cash flows and the investment outlays are discounted at the “required rate of return” to find the net present value (NPV). Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operating cash flows and capturing the costs of debt (and other capital) in the discount rate. The required rate of return is the discount rate that investors should require given the riskiness of the project. This discount rate is frequently called the “opportunity cost of funds” or the “cost of capital.” If the company can invest elsewhere and earn a return of r, or if the company can repay its sources of capital and save a cost of r then it is the company’s opportunity cost of funds. If the company cannot earn more than its opportunity cost of funds on an investment, it should not undertake that investment. Unless an investment earns more than the cost of funds from its suppliers of capital, the investment should not be undertaken.
Capital budgeting cash flows are not accounting net income. Accounting net income is reduced by non-cash charges such as accounting depreciation. Furthermore, to reflect the cost of debt financing, interest expenses are also subtracted from accounting net income. Accounting net income also differs from economic income, which is the cash inflow plus the change in the market value of the company. Economic income does not subtract the cost of debt financing, and it is based on the changes in the market value of the company, not changes in its book value (accounting depreciation).
Important Concepts in Capital Budgeting
When performing capital budgeting, you need to know the following concepts:
- A sunk cost is one that has already been incurred. You cannot change a sunk cost. Today’s decisions, on the other hand, should be based on current and future cash flows and should not be affected by prior, or sunk, costs.
- An opportunity cost is what a resource is worth in its next-best use. For example, if a company uses some idle property, what should it record as the investment outlay: the purchase price several years ago, the current market value, or nothing? If you replace an old machine with a new one, what is the opportunity cost? If you invest $10 million, what is the opportunity cost? The answers to these three questions are, respectively: the current market value, the cash’ flows the old machine would generate, and $10 million (which you could invest elsewhere). An incremental cash flow is the cash flow that is realized because of a decision: the cash flow with a decision minus the cash flow without tb.at decision. If opportunity costs are correctly assessed, the incremental cash flows provide a sound basis for capital budgeting.
- An externality is the effect on other things besides the investment itself. Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative. If possible, these should be part of the investment decision. Sometimes externalities occur outside of the company. An investment might benefit (or harm) other companies or society at large, and yet the company is not compensated for these benefits (or charged for the costs). Cannibalization is one externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company.