Capital Budgeting

Capital Budgeting Process

 

Capital budgeting I the process that managers use to make capital investment decisions.  These decisions involve an investment in major capital assets, such as new machinery, replacement machinery, new plants, new products, and research and development projects.

 

  • ·        Capital Investment Decisions – In general managers make two types of investment decisions:  (1) Screening decisions require managers to evaluate a proposed capital investment to determine whether it meets some minimum criteria; (2) Preference decisions require managers to choose from among a set of alternative capital investment opportunities.  Because companies typically have limited funds to invest in capital projects, managers must prioritize and select from the available options.  Capital investment decisions can also be categorized based on whether the projects are independent or mutually exclusive:  (1) Independent projects are unrelated to another, so that investing in one project does not precluded or affect the choice about other alternatives; (2) Mutually exclusive projects require making a choice among competing alternatives.

 

This chapter describes four different methods that managers can use to evaluate capital investment decisions: (1) Accounting rate of return; (2) Payback Period, (3) Net Present Value; (4) Internal Rate of Return.  The first two methods are good initial screening tools but they do not incorporate time value of money.

 

  • ·        Cash Flow Versus Accounting Net Income – Net income and cash flow are not the same.  We learned this in Week 2.  For accounting purposes, revenue is recognized when it is earned, not when cash is received.  When we analyzed the cash flow statement in Week 2, we learned that depreciation is a non-cash expense, so we add depreciation to net income to get the cash flow for the period.

 

  • ·        Accounting Rate of Return – The accounting rate of return is calculated as net income divided by the original investment in assets (net income/initial investment).  To determine whether the project is acceptable (a screening decision), managers would compare the accounting rate of return with the hurdle rate set forth by the firm.  The hurdle rate is the minimum required return set forth by the firm to determine if a project is acceptable or not.  The hurdle is somewhat similar to the weighted average cost of capital (WACC), but the WACC is based on the capital structure of the firm while the hurdle rate is based on the required return set forth by management which could be greater than the WACC.  As we learned in Week 2, firms desire returns higher the minimum, so they will set hurdle rates higher than the minimum to get good residual growth in net income and higher firm value or stock price.

 

  • ·        Payback period – The payback period is the amount of time needed for a capital investment to “pay for itself.”  In the simplest case in which cash flows are equal each year, the payback period is calculated as follows: initial investment/annual net cash flow.  The calculated payback period must the firm’s desired payback period for projects.  The payback method provides a very useful initial screening tool based on how long it will take for the project to recoup its original investment.  The payback period, however does not incorporate time value of money.