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capital budgeting process
- 1. Capital Budgeting Process The specific capital budgeting procedures that the manager uses depend on the manger's level in the organization and the complexities of the organization and the size of the projects. The typical steps in the capital budgeting process are as follows: • Brainstorming. Investment ideas can come from anywhere, from the top or the bottom of the organization, from any department or functional area, or from outside the company. Generating good investment ideas to consider is the most important step in the process . • Project analysis. This step involves gathering the information to forecast cash flows for each project and then evaluating the project's profitability. • Capital budget planning. The company must organize the profitable proposals into a coordinated whole that fits within the company's overall strategies, and it also must consider the projects' timing. Some projects that look good when considered in isolation may be undesirable strategically. Because of financial and real resource issues, the scheduling and prioritizing of projects is important. • Performance monitoring. In a post-audit, actual results are compared to planned or predicted results, and any differences must be explained. For example, how do the revenues, expenses, and cash flows realized from an investment compare to the predictions? Post-auditing capital projects is important for several reasons. First, it helps monitor the forecasts and analysis that underlie the capital budgeting process. Systematic errors, such as overly optimistic forecasts, become apparent. Second, it helps improve business operations. If sales or costs are out of line, it will focus attention on bringing performance closer to expectations if at all possible. Finally, monitoring and post-auditing recent capital investments will produce concrete ideas for future investments. Managers can decide to invest more heavily in profitable areas and scale down or cancel investments in areas that are disappointing. Complexity of Capital budgeting Process The budgeting process needs the involvement of different departments in the business. Planning for capital investments can be very complex, often involving many persons inside and outside of the company. Information about marketing, science, engineering, regulation, taxation, finance, production, and behavioral issues must be systematically gathered and evaluated. The authority to make capital decisions depends on the size and complexity of the project. Lower-level managers may have discretion to make decisions that involve less than a given amount of money, or that do not exceed a given capital budget. Larger and more complex decisions are reserved for top management, and some are so significant that the company's board of directors ultimately has the decision-making authority. Like everything else, capital budgeting is a cost-benefit exercise. At the margin, the benefits from the improved decision making should exceed the costs of the capital budgeting efforts. Capital Budgeting – Procedure & Decision Process
- 2. Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets. In some situations, the process may entail in acquiring assets that are completely new to the firm. In other situations, it may mean replacing an existing obsolete asset to maintain efficiency. During the capital budgeting process answers to the following questions are sought: • What projects are good investment opportunities to the firm? • From this group which assets are the most desirable to acquire? • How much should the firm invest in each of these assets? Components of Capital Budgeting Initial Investment Outlay: It includes the cash required to acquire the new equipment or build the new plant less any net cash proceeds from the disposal of the replaced equipment. The initial outlay also includes any additional working capital related to the new equipment. Only changes that occur at the beginning of the project are included as part of the initial investment outlay. Any additional working capital needed or no longer needed in a future period is accounted for as a cash outflow or cash inflow during that period. Net Cash benefits or savings from the operations: This component is calculated as under:- (The incremental change in operating revenues minus the incremental change in the operating cost = Incremental net revenue) minus (taxes) plus or minus (changes in the working capital and other adjustments). Terminal Cash flow: It includes the net cash generated from the sale of the assets, tax effects from the termination of the asset and the release of net working capital. The Net Present Value technique: Although there are several methods used in Capital Budgeting, the Net Present Value technique is more commonly used. Under this method a project with a positive NPV implies that it is worth investing in. Example: A company is studying the feasibility of acquiring a new machine. This machine will cost $350,000 and have a useful life of three years after which it will have no salvage value. It is estimated that the machine will generate operating revenues of $300,000 and incur $75,000 in annual operating expenses over the useful life of three years. The project requires an initial
- 3. investment of $15,000 in working capital which will be recovered at the end of the three years. The firm’s cost of capital is 16%. The firm’s tax rate is 25%. To simplify the problem, depreciation is not considered. Solution: Initial Investment is $350,000 Initial Net Working Capital is $15,000 Present Value of the annual operating cash flow after tax = ($300,000-$75,000) x (1-0.25) x PVIFA(16%,3years) = $225,000 x 0.75 x 2.2459 = $378,996 Note: The number 2.2459 can be obtained by using an ordinary calculator. Procedure to be followed: For Year 1, divide 1 by 1.16 = 0.8621 For Year 2, the calculator screen shows 0.8621, press the = key, you will get 0.7432 For Year 3, the calculator screen shows 0.7432, press the = key, you will get 0.6406 Add up all the three to get 2.2459 Since the asset will not have any salvage value at the end of the third year we need not calculate the Present Value. Present Value of the net working capital at the end of the project = $15,000 x PVIFA(16%,3rd year) = $15,000 x 0.6406 = $9,609 Net Present Value = ($ 350,000) + ($ 15,000) + $ 378,996 + $ 9,609 = $ 23,605 Since the NPV is positive it is feasible to purchase the equipment.