What is Capital Budgeting?
Capital budgeting refers to the decision-making process that companies make with regards to which capital-intensive projects they should pursue. Such capital-intensive projects could be anything from opening a new factory, a significant workforce expansion, entering a new market, the research and development of new products, etc.
Whether such investments are worthwhile depends on the approach that the company uses to evaluate them. 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 said metrics.
Best Practices in Capital Budgeting
While most big companies use their own laid-out processes to evaluate certain projects in place, there are a few practices that should be used as “gold standards” in order 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 given 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. It is because sunk costs have already occurred and have already had their impact on the business’ financial statements. As such, they should not be taken into consideration when assessing the profitability of future projects since this will 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 the projects are worth more than cash flows received later. Congruent with the concept of time value of money, cash flows that are received soon will be more valuable since 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, which makes them more valuable than the cash flow that occurs at a later date.
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 a given project is over another one. To calculate this, management may take the difference in the NPV, IRR, or payback periods of two projects. Doing so provides a valuable 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 the 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, meaning that this is also another constant across multiple projects. Therefore, it can be ignored as well.
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