Capital budgeting refers to the decision-making process that companies follow with regard to which capital-intensive projects they should pursue. Such capital-intensive projects could be anything from opening a new factory to a significant workforce expansion, entering a new market, or the research and development of new products.
Whether such investments are judged worthwhile depends on the approach that the company uses to evaluate them. This is where capital budgeting comes in. For instance, a company may choose to value its projects based on the internal rate of return they provide, their net present value, payback periods, or a combination of such metrics.
Best Practices in Capital Budgeting
While most big companies use their own processes to evaluate projects in place, there are a few practices that should be used as “gold standards” of capital budgeting. This can help to guarantee the fairest project evaluation. A fair project evaluation process tries to eliminate all non-project related factors and focus purely on assessing a project as a stand-alone opportunity.
Decisions based on actual cash flows
Only incremental cash flows are relevant to the capital budgeting process, while sunk costs should be ignored. This is because sunk costs have already occurred and had an impact on the business’ financial statements. As such, they should not be taken into consideration when assessing the profitability of future projects. Doing so could skew the perception of management.
Cash flow timing
Analysts try to predict exactly when cash flows will occur, as cash flows received earlier in the life of projects are worth more than cash flows received later. Congruent with the concept of the time value of money, cash flows that are received sooner are more valuable. This is because they can be used right away in other investment vehicles or other projects. In other words, cash flows that occur earlier have a larger time horizon. This makes them more valuable than cash flow that occurs at a later date. Cash flow considerations are an important factor in capital budgeting.
Cash flows are based on opportunity costs
Projects are evaluated on the incremental cash flows that they bring in over and above the amount that they would generate in their next best alternative use. This is done to quantify just how much better one project is over another. To calculate this, management may consider the difference in the NPV, IRR, or payback periods of two projects. Doing so provides a valuable capital budgeting perspective in evaluating projects that provide strategic value that is more difficult to quantify.
Cash flows are computed on an after-tax basis
Since interest payments, taxes, and amortization and depreciation are expenses that occur independently of a project, they should not be taken into account when assessing a project’s profitability. Assuming that the company will draw upon the same source of capital to finance such projects and that the cash flows of all projects will be recorded in the same tax environments, these considerations are essentially constants. Thus, they can be removed from the decision-making process.
Financing costs are ignored from the calculations of operating cash flows
Financing costs are reflected in the required rate of return from an investment project, so cash flows are not adjusted for these costs. The costs are typically congruent with the company’s Weighted Average Cost of Capital (WACC), which represents the cost the company incurs to run its current capital structure. During project valuations, the discount rate used is often the WACC of the company. Therefore, this is another constant that can be ignored as well.