Capital Budgeting

10 Key excerpts on "Capital Budgeting"

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  Fundamentals of Finance

  Investments, Corporate Finance, and Financial Institutions

  • Mustafa Akan, Arman Teksin Tevfik(Authors)
  • 2020(Publication Date)
  • De Gruyter

    (Publisher)

  10 The Basics of Capital Budgeting 10.1 Introduction We now focus on investment principle (Capital Budgeting). The capital budget must re-late to the firm ’ s mission and its abilities to meet competitive challenges. Information from marketing, finance, and production analyses are put together to form cash flow estimates of proposed projects. Project risk considerations enter the capital budget analysis because higher-risk projects should be expected to earn higher returns than lower-risk projects. The capital budget evaluation is done with the goal of identifying projects that will increase shareholder wealth. This chapter examines the process of evaluating projects and determining the inputs that are used to form the cash flow estimates. 10.2 Data and Stages in Capital Budgeting The capital budget must relate to the firm ’ s mission and its abilities to meet compet-itive challenges. Information from marketing, finance, and production analyses are put together to form cash flow estimates of proposed projects. Capital Budgeting is the process of identifying, evaluating, and implementing a firm ’ s investment opportunities. 1 Various methods of Capital Budgeting are avail-able. However, it is the continuous planning and feedback cycles of capital budget-ing that allow a company to grow and prosper. Capital Budgeting helps companies in the following areas: – better working capital, the capital used for day-to-day expenses – profit maximization due to proper budgeting of funds – an increase in firm value when cash flow benefits exceed capital expenditures – proper investment in assets that generate earning power and profitability Capital Budgeting decisions can involve mutually exclusive or independent projects. Mutually exclusive projects mean that selecting one project precludes others from being undertaken. Independent projects are not in direct competition with one another.

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
  • 2016(Publication Date)
  • Wiley

    (Publisher)

  As you will see, not all Capital Budgeting techniques are equal. The best techniques are those that determine the value of a capital project by discounting all of the cash flows generated by the project and thus account for the time value of money. We focus on these techniques in this chapter. In the final analysis, Capital Budgeting is really about management’s search for the best capital projects – those that add the greatest value to the firm. Over the long term, the most suc-cessful firms are those whose managements consistently search for and find capital investment opportunities that increase firm value. WEB You can read about a real-world example of how Capital Budgeting techniques are used at http://www.acq.osd.mil/dpap/cpf/docs/contract_pricing_finance_guide/vol2_ch9.pdf and http://www.hmrc.gov.uk/ebu/npv-and-example.pdf The Capital Budgeting Process The Capital Budgeting process starts with a firm’s strategic plan, which spells out its strategy for the next three to five years. Division managers then convert the firm’s strategic objectives into business plans. These plans have a one-year to two-year time horizon, provide a detailed description of what each division should accomplish during the period covered by the plan and have quantifiable targets that each division is expected to achieve. Behind each division’s busi-ness plan is a capital budget that details the resources management believes it needs to get the job done. The capital budget is generally prepared jointly by the CFO’s staff and financial staff at the divisional and lower levels and reflects, in large part, the activities outlined in the divisional business plans. Many of these proposed expenditures are routine in nature, such as the repair or purchase of new equipment at existing facilities. Less frequently, firms face broader strategic deci-sions, such as whether to launch a new product (as in Airbus’ case), build a new plant, enter a new market or buy a business.

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  Corporate Finance

  Theory and Practice in Emerging Economies

  • Sunil Mahajan(Author)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  Capital Budgeting | 91 Capital Budgeting Companies strive to grow by investing in projects. Growth is a key objective of any business and the only way to grow is to keep investing in projects. Identifying and selecting projects that add value to the firm is called Capital Budgeting. It refers to the decision and process of investing in long-term assets—buildings, plant and machinery, and intangibles such as brands and patents. As the name suggests, the company is budgeting for capital to be invested for long-term growth. Investment in long-term projects is amongst the most critical decisions that a company takes. Capital investment is a high-value, high-impact decision which has the potential to significantly alter the fortunes of a company. When Nokia decided to invest in mobile telephones, using the Global system for mobile communication (GSM) technology, it was quite a change from paper products, footwear, tires and radio telephony that comprised the company’s product portfolio at the time. The decision paved the way for its global dominance for two decades, from the mid-1990s to the 2000s. Recently, however, it was unable to correctly judge the shift in market preference to smartphones, and Nokia decided not to invest wholeheartedly in this space. The decision proved fatal and the company not only lost its leadership position but had to sell its mobile business to Microsoft Ltd in 2014. Investment in long-term projects may fall under any of the following categories: 1. Expansion in existing capacities: a cement company increasing its capacity, from the existing 10 million to 15 million tons 2. Diversifying into new products: the Mahindra Group diversifying into real estate in the early years of the twenty-first century through Mahindra Lifespace Developers Ltd 3. Expanding to new markets/customers: an Indian bank going global and opening branches in the United Kingdom (UK), Maruti Ltd moving to the premium car segment and targeting a new set of customers 4.

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  CFIN

  • Scott Besley, Eugene Brigham, Scott Besley(Authors)
  • 2021(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  In Chapter 10 we show how the cash flows associated with Capital Budgeting projects are estimated and how risk is reflected in Capital Budgeting decisions. Capital Budgeting The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year. 197 CHAPTER 9: Capital Budgeting Techniques Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Effective Capital Budgeting can improve both the timing of asset acquisitions and the quality of assets pur- chased. A firm that forecasts its needs for capital assets in advance will have an opportunity to purchase and in- stall the assets before they are needed. Unfortunately, like Decopot, many firms, especially smaller ones, do not order capital goods until they approach full capacity or are forced to replace worn-out equipment. If many firms order capital goods at the same time, backlogs result, prices increase, and firms are forced to wait for the de- livery of machinery; in general, the quality of the capital goods deteriorates. If a firm foresees its needs and pur- chases capital assets early, it can avoid these problems. Finally, Capital Budgeting is important because the acquisition of fixed assets typically involves substan- tial expenditures, and before a firm can spend a large amount of money, it must have the funds available. Large amounts of money are not available automatically. Therefore, a firm contemplating a major capital expendi- ture program must arrange its financing well in advance to ensure the required funds are available.

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  The Power of Accounting

  What the Numbers Mean and How to Use Them

  • Lawrence D. Lewis, Lawrence Lewis(Authors)
  • 2012(Publication Date)
  • Routledge

    (Publisher)

  Many managerial accounting texts point out that in the short run many costs are fixed and in the long run few, if any, are fixed. This is true, but such a statement could lead one to the conclusion that there is only a short run and a long run and nothing in between. In reality, the budgeting process encompasses a continuum, as Figure 5.1 illustrates.

  Figure 5.1

  Capital Budgeting Decisions

  Decisions relating to capital expenditures are not easily reversible. They generally involve large sums of money and long periods of time. So a poor decision of this sort is going to cost a lot of money and it is a decision you are going to have to live with for a long time. Not surprisingly, these are often thought to be among the most important decisions an organization can make.

  More than one organization has declared bankruptcy solely because someone or some committee made a poor Capital Budgeting decision. Take a trip through your local industrial district and note the shuttered factories and warehouses. In how many cases had someone miscalculated their firm’s future cash flows?

  Short-term decisions relate more to day-to-day operations, while Capital Budgeting involves strategic decisions that affect long-term goals. Capital Budgeting decisions may include decisions to buy or not to buy major pieces of equipment, to buy equipment from one manufacturer instead of another, to buy one machine versus a similar one, to introduce or not introduce a new product line, to expand overseas, to build a new plant and so on. Both short-term and long-term decisions should utilize incremental analysis.

  In our discussion in the previous chapter we stressed that when making short-term decisions we want to rely only on relevant information. And we defined relevant information as “expected future information that varies amongst alternatives.” The same approach and the same rules apply equally to long-term decisions. Both types of decisions should rely on a differential analysis of cash inflows and outflows.

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  Hospitality Finance and Accounting

  Essential Theory and Practice

  • Rob Ginneken, Rob Ginneken, Rob van Ginneken, Rob van Ginneken(Authors)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  5 Capital Budgeting Planning for long-term asset expenditure

  Learning outcomes

  At the end of this chapter, readers should:

  • understand the importance of ongoing capital investment in hospitality firms;
  • differentiate between the accounting treatment of capital investment and repair and maintenance expenditure;
  • understand the notion of the time value of money;
  • be able to apply investment appraisal techniques.

  Theory

  James W. HesfordMichael J. Turner

  Introduction

  The purpose of this chapter is to give you the knowledge and tools to evaluate long-term capital investments. In addition to day-to-day operational decision-making, hospitality managers also engage in planning. They develop short- and long-term budgets, and frequently make decisions and/or recommendations for long-term capital investments. Capital Budgeting is the term used to describe the process of developing budgets for capital investment. Long-term capital investments establish a firm’s capabilities and frequently define the identity of a firm. The firm’s survival depends on the firm making the right decisions. Capital investments require large cash outlays and have a long-term impact on future profitability. Undertaking a “bad” project could lead to bankruptcy, whereas not undertaking a “good” project could make the firm less competitive, also threatening its long-term viability. Accordingly, hospitality managers must effectively plan for long-term capital investment.

  In every hospitality organisation there is an ongoing need to replace assets, assets that include furniture, fixtures and equipment (FF&E). Further, hospitality firms operate in highly uncertain and competitive environments, with demand fluctuating due to the economy, terrorist events, natural disasters and customers’ preferences. Competing in this environment, managers must think strategically about capital investment. For example, given a limited amount of funding, should the hotel expand by acquiring additional assets (e.g. a swimming pool or fitness facility) or should some existing assets be upgraded?

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  Managerial Accounting

  • James Jiambalvo(Author)
  • 2019(Publication Date)
  • Wiley

    (Publisher)

  Capital expenditure decisions are investment decisions involving the acquisition of long-lived assets. A capital budget is the final list of approved acquisitions. Two of the primary methods for evaluating investment opportu- nities, which take into account the time value of money, are the net present value method (NPV) and the internal rate of return method (IRR). The net present value method equates all cash flows to their present values. If the sum of the present values of cash inflows and outflows (i.e., the NPV) is zero or positive, the return on the invest- ment equals or exceeds the required return and the investment should be made. The internal rate of return method calculates the rate of return that equates the present value of the future cash flows to the ini- tial investment. If this rate of return is equal to or greater than the required rate of return, the investment is warranted. LEARNING OBJECTIVE 2 Calculate the depreciation tax shield and evaluate long-run decisions, other than invest- ment decisions, using time value of money techniques. In analyzing cash flows for a net present value analysis or an inter- nal rate of return analysis, remember that depreciation is not a cash flow but the tax savings generated by depreciation are relevant to the analysis. The tax savings owing to depreciation are referred to as the depreciation tax shield. NPV and IRR are also used to evaluate long-run decisions that are not Capital Budgeting decisions. Examples include outsourcing decisions and decisions related to multiyear advertising campaigns. LEARNING OBJECTIVE 3 Use the payback period and the accounting rate of return methods to evaluate investment opportunities, and explain why managers may concen- trate erroneously on the short-run profitability of invest- ments rather than their net present values. The payback method evaluates capital projects in terms of how quickly the initial investment is recovered by future cash inflows.

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  Financial Management for Nonprofit Organizations

  Policies and Practices

  • Jo Ann Hankin, Alan Seidner, John Zietlow(Authors)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 9

  LONG-RANGE FINANCIAL PLANNING AND Capital Budgeting

  1. 9.1 INTRODUCTION
  2. 9.2 PLANNING FOR THE FUTURE
     1. (a) Importance of Long-Range Financial Planning
     2. (b) CFO’s Role in Financial Planning and Capital Budgeting
     3. (c) Long-Range Financial Planning Process
     4. (d) Financial Planning Basics
     5. (e) Develop a Financial Model
     6. (f) Project and Reevaluate Target Liquidity
  3. 9.3 FINANCIAL EVALUATION OF NEW AND EXISTING PROGRAMS
     1. (a) Simple Portfolio Analysis
     2. (b) Advanced Portfolio Analysis
     3. (c) Annual Necessary Investment
  4. 9.4 Capital Budgeting: FINANCIAL EVALUATION OF PROJECTS THAT ARISE FROM EXISTING PROGRAMS
     1. (a) Example 1: Net Present Value and Benefit-Cost Ratio Illustrated
     2. (b) Example 2: Equivalent Annual Cost Illustrated
     3. (c) How to Manage the Total Capital Budget
     4. (d) Capital Budget and Capital Rationing
     5. (e) Rationing the Capital
  5. 9.5 FINANCIAL EVALUATION OF MERGERS, JOINT VENTURES, AND STRATEGIC ALLIANCES
     1. (a) Mergers and Acquisitions
     2. (b) Motives for Mergers and Acquisitions
     3. (c) Partnerships, Joint Ventures, and Strategic Alliances
     4. (d) Strategic Alliances
  6. 9.6 FINANCIAL PLANNING AND Capital Budgeting IN PRACTICE
  7. 9.7 CONCLUSION
  8. APPENDIX 9A: CASE STUDY: KIAWAH ISLAND COMMUNITY ASSOCIATION
  9. APPENDIX 9B: EVALUATING SOCIAL ENTERPRISES

  9.1 INTRODUCTION

  This chapter outlines the financial manager’s role in the long-range financial planning and capital allocation processes. Managing growth is one of the reasons organizations plan and do financial evaluations. The chapter begins by developing the financial plan for existing and already approved programs, then shows how the financial evaluation of new program alternatives such as new ventures are made. We then demonstrate how you may evaluate individual capital expenditures made as part of program implementation. A financial approach to evaluating mergers and acquisitions, partnerships, joint ventures, and strategic alliances follows. We conclude with a survey of actual practices in the areas of long-range financial planning and Capital Budgeting, to help you see what your peer organizations are doing.

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  Financial Management for Nonprofit Organizations

  Policies and Practices

  • John Zietlow, Jo Ann Hankin, Alan Seidner, Tim O'Brien(Authors)
  • 2018(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 9 LONG-RANGE FINANCIAL PLANNING AND Capital Budgeting

  1. 9.1 INTRODUCTION
  2. 9.2 PLANNING FOR THE FUTURE
     1. (a) Importance of Long-Range Financial Planning
     2. (b) CFO’s Role in Financial Planning and Capital Budgeting
     3. (c) Deferred Maintenance: A Cautionary Tale
     4. (d) Long-Range Financial Planning Process
     5. (e) Financial Planning Basics
     6. (f) Develop a Financial Model
     7. (g) Project and Reevaluate Target Liquidity
     8. (h) Based on Our Financial Policies and Structure, How Fast Can We Grow?
  3. 9.3 FINANCIAL EVALUATION OF NEW AND EXISTING PROGRAMS
     1. (a) Simple Portfolio Analysis
     2. (b) Advanced Portfolio Analysis
     3. (c) Annual Necessary Investment
  4. 9.4 Capital Budgeting: FINANCIAL EVALUATION OF PROJECTS THAT ARISE FROM EXISTING PROGRAMS
     1. (a) Example 1: Net Present Value and Benefit-Cost Ratio Illustrated
     2. (b) Example 2: Equivalent Annual Cost Illustrated
     3. (c) How to Manage the Total Capital Budget
     4. (d) Capital Budget and Capital Rationing
     5. (e) Rationing the Capital
  5. 9.5 FINANCIAL EVALUATION OF MERGERS, JOINT VENTURES, AND STRATEGIC ALLIANCES
     1. (a) Mergers and Acquisitions
     2. (b) Motives for Mergers and Acquisitions
     3. (c) Partnerships, Joint Ventures, and Strategic Alliances
     4. (d) Strategic Alliances
  6. 9.6 FINANCIAL PLANNING AND Capital Budgeting IN PRACTICE
  7. 9.7 CONCLUSION
  8. APPENDIX 9A: CASE STUDY: KIAWAH ISLAND COMMUNITY ASSOCIATION
  9. APPENDIX 9B: EVALUATING SOCIAL ENTERPRISES

  9.1 INTRODUCTION

  If we consider that nonprofit boards carry a primary responsibility for the fiscal life of the organizations that they govern, then it follows that long-range financial planning is a primary method for carrying out that responsibility.1 Very often, the fiscal responsibility role is viewed within the frame of the annual budget but we postulate that nonprofit organizations need to reframe this to incorporate long-range planning.2

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates, Stuart L. Gillan(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  10.2 Net Present Value 10-13 Concluding Comments on NPV Some concluding comments about the NPV method are in order. First, as you may have noticed, the NPV computations are rather mechanical once we have estimated the cash flows and the cost of capital. The real difficulty is estimating or forecasting the future cash flows. Although this may seem to be a daunting task, managers with experience in producing and selling a particular type of product can usually generate fairly accurate estimates of sales vol- umes, prices, and production costs. Most business managers are routinely required to make decisions that involve expectations about future events. In fact, that is what business is really all about—dealing with uncertainty and making decisions that involve risk. Second, estimating project cash flows over a long forecast period requires skill and judgment. There is nothing wrong with using estimates to make business decisions as long as they are based on informed judgments and not guesses. Problems can arise with the cash flow estimates when a project team becomes overly enamored with a project. In wanting a particular project to succeed, a project team can be too optimistic about the cash flow projections. It is therefore very important that Capital Budgeting decisions be subject to ongoing and postaudit review. In conclusion, the NPV approach is the method we recommend for making capital investment decisions. It provides a direct (dollar) measure of how much a project will increase the value of the firm. NPV also makes it possible to correctly choose between mutually exclu- sive projects. The accompanying table summarizes NPV decision rules and the method’s key advantages and disadvantages. DECISION MAKING EXAMPLE 10.1 The IS Department’s Capital Projects Situation Suppose you are the manager of the information systems (IS) department of the frozen pizza manufacturer we have been discussing.

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