Capital projects compete for scarce funds and usually require economic analysis to justify their capitalization (typically funding with borrowed money). The analysis will compare projects against one another and against a predetermined acceptable standard. Capital budgeting seeks to answer three main questions:
- Which of several mutually exclusive (only one of several alternatives can be chosen) investments should be selected?
- How many independent (as many can be chosen as is wise to do so) projects, in total, should be accepted?
- When should capital be expended to accomplish the project?
Capital budgeting encompasses all steps and processes involved in planning and programming expenditures for ventures (projects, campaigns, etc.) whose initial investment requirements and subsequent cash flows are expected to exceed the monetary and scheduling bounds of the operating budget.
Capital budget projects do not just appear from thin air; they are most often the result of creative and innovative thinking by managers charged with accomplishing the firm’s goals and objectives in the most cost-effective manner possible. Not all capital project decision-making depends on capital budgeting. Mandated “decisions” or required projects with no alternatives are usually “no-brainers” and don’t merit the time and effort required for a meaningful capital budget analysis.
Don’t be misled by the word “budgeting.” FMs are so often engaged in developing and executing operating budgets that [they] begin to narrow [their] definition to that specific application. Remember that budgeting is merely a management tool used for planning and controlling.
The Basics of Capital Budgeting
Every capital budget project is assigned a useful or economic life. This useful life is either determined by the firm or prescribed by the income tax codes, depending on whether the useful life is used for managerial reporting or paying taxes. This is the number of years the investment can be expected to bring in adequate positive cash inflows or otherwise benefit the company. The useful life assigned to a project is often shorter than its maximum possible life. This is done for several reasons:
- Cash flows in distant years are harder to predict than those in the more immediate future.
- Technology advances can render an investment obsolete and hence useless, even though it is fully capable of functioning as originally intended for many more years.
- If the market for which the asset was acquired disappears, goes out of style, or is just discontinued, the asset is no longer useful even if it has many years of life remaining.
- The useful life only applies to its immanent use. What happens to the investment after it is passed on to another buyer is not considered in the immediate user’s capital budget analysis.
The useful life is that time period during which the company expects to make profitable or otherwise beneficial use of the investment. The end of an investment’s useful life is called the investment horizon. Beyond that point in time, predictions regarding cash flows are not clearly visible or discernable.
The concept of the time value of money is based on the premise that money can be safely invested and grow to a larger amount at some time in the future. This means that an amount of money today can be considered equivalent to a future larger amount. Conversely, a larger future amount of money can be considered equivalent to a smaller present amount. The amount of money we have today or the equivalent of a larger future amount of money “brought back” to today’s value is called its present value. Logically, a future amount of money is called a future value or future worth.
As private citizens, we are rewarded by the time value of money concept whenever we invest in a savings account or buy a savings bond and receive a greater sum of money in the future than we invested in the present. Conversely we are “penalized” by the time value of money concept whenever we use a loan to buy a car or take a mortgage on a house and end up paying a larger future amount for the item (over time) than its present value at the time of purchase.
The time value of money principles can be applied to two different types of dollar amounts: single sums or periodic sums. A single or lump sum investment is illustrated by a present-day deposit made in a savings account that is then left untouched to accumulate interest. A periodic sum investment or annuity is illustrated by a 401k retirement plan, where a number of fixed (predetermined) deposits are made over a period of years to a savings account on a regular, periodic basis. Both investments are expected to grow to larger future amounts than would be possible without investing; only the timing of the investment(s) is essentially different.
In capital budgeting, a lump sum amount may be represented by the initial cost of the investment (present value) or the investment’s eventual salvage value (future value). Annuities could represent the stream of future periodic costs (maintenance) and benefits (sales) expected to accrue over the investment’s useful life.
Capital Budgeting Risks
A high element of risk surrounds capital budget decision-making for several reasons:
- The entire firm is affected by capital budget decisions. The project may be sponsored by only one department, but the ripple effects can be significant. Project failure may hurt other departments [that] were counting on the project’s expected cost savings or revenue generation.
- Capital budget decisions impact the firm for an extended time period. While faulty operating budget decisions can be corrected at least annually (or as often as the budgets are reformulated), a firm may have to live with its capital budget decisions for years to come with little hope of recovery in the event of failure.
- Capital budget investments involve large sums of capital. The firm will usually finance its capital budget projects by borrowing funds from lending institutions, thus impacting working capital. Capital budget projects that cannot be financed internally require the firm to assume debt which must be paid back almost regardless of the company’s future profitability. The capital budget project might have been approved with the expectation that it would help insure that future profitability.
- Assuming long-term debt locks the company into a steady outflow of cash. Using equity money from retained earnings to finance capital expenditures would not result in such a cash drain.
- Acquiring long-term debt to finance capital expenditures could lock the firm into restrictive conditions imposed by the lender that may limit flexibility and risk-taking necessary to take advantage of future market opportunities.
- Financing capital expenditures using lower-cost, short-term debt increases the risk that interest rates may be higher at the time of renewal or economic conditions may have changed so drastically that lenders no longer have funds available to lend.
- The final results from capital budget decisions may not become apparent for many years. Research and development efforts (including facilities support requirements) may not bear fruit until long after they are initially approved.
- Capital budget decisions are almost impossible to reverse once set in motion. Backing out of intertwined, long-term commitments is very difficult.
- The worthiness of capital project investments rests in predictions of future cost and revenue streams. If the initial forecasts are wrong or economic assumptions do not bear fruit, the venture may fail.
- Production and sales may change, further affecting profits and dividends. Dissatisfied shareholders may reconsider further investment in the firm, and new shareholders may be scared away.
- In most firms, the awarding of capital budget dollars is the result of a competition between projects, so choosing the right projects is crucial. It probably does a company no good to re-roof the manufacturing center if the firm goes out of business the next year because funds were not available to modernize the plant’s equipment and remain competitive or to expand capacity and retain market share.
- Long lead times for design, financing, procurement, and/or construction mean that assets obtained through capital budgeting must be timed to come on line at the right time. Requesting funding for an uninterruptible power supply (UPS) and generator station after the firm loses customers unhappy with service outages is a little like closing the barn door after the horses have already galloped away.
- Cash flows resulting from capital projects must be carefully predicted and timed. A capital budget expenditure, however worthy it may appear to be at the time, may not benefit the company if its financing structure forces the firm into bankruptcy.
- Calculating rates of return and costs of capital are often conceptually and empirically difficult. There are no “magic formulas” that will always divine the correct figures.
- Many non-financial factors add additional risk to the venture. The marketing department may predict a demand for a new product, but if the customers don’t materialize, the capital expenditures made to meet the unrealized demand can cause serious harm to the firm.
- Many capital budgeting projects also will affect the number and types of employees. Investments in staffing, training, supplying, and officing new employees may be wasted
- When comparing project RORs against the firm’s IRR, they are generally assumed to incur the same degree of risk. If the project unknowingly incurs a degree of risk greater than the firm typically accounts for, the analysis may lead to a wrong conclusion. Capital budget investments that involve greater risk require an ROR much higher than the firm’s IRR in order to justify their approval.
Types of Projects, Decisions
Most capital budget investments center around the following types of revenue-/cost-saving asset decisions:
- Capacity expansion. Will we be able to increase production and, hence, revenue flows?
- Asset replacement. Can we gain efficiencies from advanced technology?
- Asset renewal or enhancement. Can we gain efficiencies or otherwise enhance revenues by refurbishing, remodeling, or otherwise “bettering” the asset?
- Buy, build, or lease. What means of asset acquisition offers the best return?
- Cost reduction. Will automating manual processes increase productivity?
- New product or service. Will the expected cash flows warrant investment in the venture?
- Compliance. How can we most cost effectively make this “investment” that yields no tangible returns?
Questions relevant to the capital budgeting process include the following:
- Can savings and costs be reasonably calculated?
- Can we compare projects directly competing for the same purpose?
- Can we compare projects directly competing for different purposes?
- How large should investments be?
- What is the maximum level of dollar benefits?
- How much will overall costs be lowered by further investments?
- How much will overall revenues be increased by further investments?
- What is the rate of return on investment?
- How soon will the investment be paid off by savings?