June 16, 2021

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Capital Budgeting Explained

Capital Budgeting Explained

Financial plans are guides that allow you to navigate the financial capabilities of an enterprise and choose effective actions. Budget planning of income and expenses, for instance, is needed to save money, to be efficient in financial management, to reduce non-productive expenses and losses, as well as to increase the reliability of planned indicators. In this article, we are going to review capital budgeting.

Capital Budgeting Explained

Definition

To understand capital budgeting, you must understand both parts of the term. Capital in this context represents a long-term, fixed asset or capital investment such as a building. A budget is a plan that details the expected income and expenses over a period of time, often the duration of a project.

Accordingly, the term capital budgeting is the process of determining which long-term capital investments should be selected by management over a specified period of time and thus included in the capital budget. It is the planning for fixed asset investments, which is why it is also called capital asset planning. In simple words, the meaning of this term can be put as a decision made on whether to accept or reject a project. Some of the examples of capital budgeting are:

  • Cost of acquisition of permanent assets like land and building
  • Cost of replacement of the permanent asset
  • Cost of addition, expansion, improvement, and alteration of fixed asset
  • Research and development project costs.

Capital budgeting is necessary for the analysis of capital expenditure, selection of best projects, coordination between various capital expenditures, and avoiding losses. It involves every aspect of the analysis and decision-making process in the determination of long-term asset replacements and purchases. Capital investment projects are among the most important financial investments made by a business owner as they involve large amounts of money.

Decisions often involve an unusually high amount of risk. Also, they are typically not easy to reverse and often impact operations for years into the future. Most importantly, decisions facilitate and constrain strategy. After all, fixed assets are used to produce your company’s products. Addressing under-investment problems can also have a large business impact.

Capital investment projects can be classified into two types: stand-alone projects and mutually exclusive projects. Independent capital investment projects are projects that do not affect the cash flows of other projects. Mutually exclusive capital investment projects are projects that are similar or similar to other capital investment projects that have an impact on the cash flows of other projects.

Capital Budgeting Explained

Factors to consider

Comparing a project’s rate of return is not as easy as it sounds. There is a relatively complex financial analysis process that a business owner must go through to get there. Unless you know what you are doing, consider professional help.

The business owner must estimate the cash flows that will be generated by the project. Cash flows are often the single most difficult variable to measure when trying to determine a project’s rate of return. It is necessary to take into account both the amount and the time of the movement of funds. For example, if you are doing capital budgeting, you need to estimate about five years of cash flow.

There are two categories of cash flows related to capital budgeting. These include decision-relevant cash flows and cash flows directly relevant to the asset over its useful life. For example, you would look at annual cash savings and depreciation effects. The risk of obsolescence is also important at the decision level.

Some of the decision-relevant costs would include opportunity cost, such as replacement planning and the finetuning of the plans so that they are appropriate for the strategy. Opportunity cost is defined as the next best foregone alternative and is often used for comparison and valuation purposes. As always, relevant costs are avoidable costs. Opportunity costs are automatically considered relevant since they are decision-driven.

As a rule, cash flows are estimated for the economic life of the project and, of course, should be as accurate as possible. Relevant cash flows over the life of a fixed asset that are readily recognized by most CAP models include:

  • Initial investments in fixed assets and working capital
  • Cash from the disposal of old assets
  • Recurring operating cash flows
  • Terminal disposal price of fixed assets
  • Recovery of working capital at the end of the asset’s useful life.

When it comes to working capital, you would treat it as part of the investment cash flow and reflect other minor cash flows that occur as a consequence of the main asset. For example, filters for a coffee machine will no longer be needed after the machine is sold, but without them, it will not be able to work (depending on the model). Accordingly, working capital will be recovered. There are several cash flow forecasting techniques that business owners can use to select their projects.

Capital Budgeting Explained

Capital budgeting involves the exchange of current funds for long-term future benefits. Thus, managers can use a discounted cash flow technique and non-discounted cash flow technique to evaluate whether they should accept or reject a certain project or capital investment decision. In the first one, you have a net present value, internal rate of return, and profitability index.

With the non-discounted cash flow technique, the analyst evaluates the payback period, which is the initial investment divided by the average amount of cash the business expects to receive every year, and the accounting rate of return.

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Author: Charles Lutwidge

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