Capital Budgeting, the decision making process regarding assets, resources, principal and investments, and how they are to be utilitized within a company. "Capital investment decisions comprise the long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders" (en.wikipedia.org).
Careful budgeting is essential in marketing decisions, for any business. "Decisions on investment, which take time to mature, have to be based on the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now. Often, it would be good to know what the present value of the future investment is, or how long it will take to mature (give returns)". It could be much more profitable putting the planned investment money in the bank in order to earn interest, or to invest it.
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Gold Bar and Investment JewelryTypical Capital budget decisions include the decision to build or invest. A smaller business manager may need "to evaluate whether to spend more on advertising or increase the sales force, although it is difficult to measure the sales to advertising ratio" (www.fao.org/decrep). The following methods will evaluate Capital budgeting:
Initial Investment Outlay includes the cash needed to purchase new equipment or to construct a new building, less any 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" (www.moneyinstructor.com).
Net Cash benefits can be described as savings from operations, minus taxes and any change in working capital, which includes the net cash generated from the sale of any assets
and the effects of taxes; this is referred to as terminal cash flow.
The Capital Budgeting Process includes investing in assets or a project that will amount in value to a significant portion of the total assets of the organization. "Capital expenditure decisions, therefore, form a foundation for the future profitability of a company" (Duncan Williamson, 2005). The steps to the capital budgeting process are: establishing the project, identify and consider alternatives, the appraisal (number crunching), analyze the feasibility, plan, and monitor and audit the project.
The expenses that the project requires must be controlled, using a cost benefit, approach such as "the payback, rate of return, net present value, internal rate of return and the profitability index, there are other techniques of course; but the technique to be used will depend on a range of things, including the knowledge and sophistication of the management of the organization, the availability of computers and the size and complexity of the project under review" (Duncan Williamson, 2005).
Company management's experience within chosen projects will form a basis for projects in the future. Projects that may be undertaken are ranked by priority. An example of this is that a company may need to purchase new property and equipment or expand its present facility. Capital Budgeting includes the updating and/or improvements of an existing facility. This may mean new restrooms for employees or larger shower facilities, to accommodate the employee's needs. A company needs to weigh the effects of reinvesting, replacing equipment or buying verses leasing. Capital budgeting needs to be involved when expanding the company locally, re-locating the entire facility or expansion internationally. All of the latter necessitate the consideration of resources: Financial resources that involve financial investors, banking or loan institutions, along with a careful assessment of the risks involved. Operational funds may have to be diverted into stock options that can generate needed cash.
Social responsibility also needs to be measured. This includes providing for a company's employees safety and maintaining safety standards at all times, putting in place necessary training and safety programs. The social responsibility a company carries also takes into account the environmental responsibility of proper disposal of waste, pollution controls and protection of the surrounding ecology and the financial burden involved.
New Product or Service Development requires research and development, which can be a very expensive sector of a company. Product development is the complete process of bringing a new product to market, which involved engineering, marketing and product management. Much of developing a new product requires a careful analyzing the supply and demand of the market.
A major expense that a company has is employees. The investment a company makes in the work force can have a long-term benefit. There are considerations regarding employees; which are to hire in full-time employees, part-time employees or to utilize an employment agency that supplies workers as needed. Temporary and part-time employees may result in a savings for a company in the requirement of providing compensation and benefits. "Temporary services can be valuable to help with peak work loads or short-term needs for specific expertise. Temporaries also make sense in one-time projects, such as the implementation of a new computer system" (Keeton-Strayhorn, 2005). This consideration may prove financially beneficial regarding outsourcing office staff, laborers, maintenance and cleaning staff. Outsourcing may also be used to acquire small parts for assembly manufacturing.
An important decision making tool that needs consideration is that of the business geographic location, within a city, state or country will have a definite impact upon a capital budgeting decision. Organizations must gage their financial aspirations toward what can be lost as well as what can be gained by investing in properties, equipment and other capital within local, national and international markets.
In planning a Capital Budget Projects - as the old saying goes, "you have to spend money
to make money," the same hold true for business.
Initial Cash Requirements require that an organization meets certain initial cash requirements before they can invest in a future venture. They must also ask what the initial and long term-costs will be to invest in various business ventures.
Estimate of Project Cash Inflows & Outflows involve an organizations calculating how much cash will be spent before they will see a return in their costs or cash inflow from investing in capital ventures.
An investor's Required Rate of Return effects those who have invested in an organization did so with the expectation of earning a profit. Organizations must know what their shareholders expect and if those expectations can be met with the projects selected.
Tax Consequences may be the generating capital that may place the business in a higher tax bracket or shelter the business from such fate? Many organizations invest in capital ventures to avoid tax penalties while other company's may decide to avoid such actions. This is considered one of the risks that an organization takes in investing in a capital budget project. However, investors, and decision makers should be confident that the risks out balance the benefits.
Capital Rationing is the limit set on the amount of funds available for investment imposed by management. The process of placing a budget constraint on projects a firm can accept is referred to as 'Soft Rationing'; this means only projects that fall within the budget constraint can be accepted. Projects with a NPV greater than 0 should be accepted.
When upper management places limitations on investments and resource spending for available funds for capital investments, this is referred as 'Hard Rationing'. Hard Rationing entails the firm not being able to raise the money it needs and is forced to pass up positive NPV projects. The organization needs to select the package of projects that are within the company's resources and gives the highest NPV.
Capital Budgeting is an extremely important aspect of a firm's financial management. Although capital assets usually comprise a smaller percentage of a firm's total assets than do current assets, capital assets are long-term. Therefore, a firm that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time. Decision making tools for capital budgeting are essential for any business.
The Net Present Value technique involves discounting net cash flows for a project, then subtracting net investment from the discounted net cash flows. The result is called the Net Present Value (NPV). If the net present value is positive, adopting the project would add to the value of the company. Whether the company chooses to do that will depend on their selection strategies. If they pick all projects that add to the value of the company, they would choose all projects with positive net present values, even if that value were just $1. On the other hand, if they have limited resources, they will rank the projects and pick those with the highest NPV's.
For Example:
What would the net present value for a project with a net investment of $40,000 and the following net cash flows be if the company's cost of capital were 5%? NCF's for year one is $25,000, for year two is $36,000 and for year three is $5000.
Yr Net
Cash Flows x PVIF@5% Discounted
Cash Flows
1 $25,000 ÃÂ .952 $23,800
2 $36,000 ÃÂ .907 $32,652
3 $5,000 ÃÂ .864 $4,320
Total Discounted Cash Flows Discounted at 5%
Less: Net Investment
Net Present Value $60,772
$40,000
$20,772
The payback period is another useful tool if used in combination with Internal Rate of Return (IRR) and Net Present Value (NPV). "The payback period for an investment is the number of years required for the undiscounted sum of the returns at least to equal the initial outlay- in other words to pay it back." (Brayshaw, Samuels and Wilkes, 1990) "In times of cash shortage this may be of vital importance to the business."(Searle, 2000) Calculated as:
For example, if a project cost $100,000 and was expected to return $20,000 annually, the payback period would be $100,000 / $20,000, or 5 years.
There are two main problems with the payback period method:
1) It ignores any benefits that occur after the payback period, and so does not measure profitability
2) It ignores the time value of money
Because of these two reasons, other methods of capital budgeting like NPV, IRR, or DCF are generally preferred.
Additionally, the Internal Rate of Return (IRR) is one of the most important decision making tools a financial manager will base decisions on for funding projects. The IRR can give us the information on the project's return, whether the return is higher or lower than the opportunity cost of capital. The rule for rate of return is that the investment in any project must have of a rate of return that is higher than the opportunity cost of capital (Investopedia.com). For example; the relevant formula that will help answer these questions is: F = -P (1+i)^n - [p(1+i)((1+i)^n - 1)/i] In this formula, "F" is the future value of your investment (i.e., the value after "n" months or "n" weeks or "n" years--whatever the period over which the investments are made), "P" is the present value of your investment (i.e., the amount of money you have already invested), "p" is the payment each period, "n" is the number of periods you are interested in, and "i" is the interest rate per period.
What Is Time Value?
Imagine if you had won $10,000 and the choice was given to either take the cash now or receive it in installments. If you were like most businesses, you would choose to receive the $10,000 now. After all, any amount of time is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the time value of money demonstrates that, all things being equal, it is better to have money now rather than later.
However, why is this? A $100 bill has the same value, as a $100 bill one year from now, does not it. Actually, although the bill is the same, you can do much more with the money if you have it now: over time, you can earn more interest on your money. By receiving $10,000 today, you are poised to increase the future value of your money by investing and gaining interest over a period of time. For option B, you do not have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:
If you are choosing option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for option B, on the other hand, would only be $10,000.
Annuities are essentially series of fixed payments required from you or paid to you at a specified frequency over the course of a fixed period of time. The most common payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly (four times a year) and monthly (once a month). There are two basic types of annuities: ordinary annuities and annuities due:
In order to calculate the future value of the annuity, we have to calculate the future value of each cash flow. Let us assume that you are receiving $1,000 every year for the next five years, and you invested each payment at 5%. The following diagram shows how much you would have at the end of the five-year period:
Since we have to add the future value of each payment, you may have noticed that, if you have an ordinary annuity with many cash flows, it would take a long time to calculate all the future values and then add them together. Fortunately, mathematics provides a formula that serves as a short cut for finding the accumulated value of all cash flows received from an ordinary annuity:
C = Cash flow per period
i = interest rate
n = number of payments
If we were to use the above formula for Example 1 above, this is the result:
= $1000*[5.53]
= $5525.63
The last decision-making tool, although there are many, is the profitability index. This index attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:
For example, a ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's NPV is less then the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.
The impact that capital investment decisions have on a company's viability can be wide ranging, and have application to entities other than the company itself. Because corporations usually deal with a large quantity of money, much greater than individuals do, the analysis of each project needs to be developed into a method of its own. By using carefully placed decision making tools a company can be assured that their investments can reap the highest payoff for itself, its employees and investors.
The accountability of managing a company's capital budget method requires an accurate budget that properly discloses financial statements and forecasts. The preparing of a project budget will allow all departments of an organization to maintain their plans to reach the organizations goals. "The ongoing monitoring of budgets assesses how well departments use their resources throughout the year, and whether expenditures comply with the terms of the budget. Budget monitoring is an important tool for identifying wasteful spending and cost overruns before they become major problems" (Keeton-Strayhorn, 2005).
References:
Brealey, R.A., Myers, S.C. & Marcus, A.J., (2004). Fundamentals of Corporate Finance
(4th ed.). McGraw-Hill/Irwin. New York, New York.
Cartet, S., Macdonald, N.J., & Cheng, D.C.B., (1997). Basic Finance for Marketers
Chapter 6-Investment Decisions -Capital Budgeting. Retrieved November 19, 2005 from http://www.fao.org/docrep/W4343E/w4343e07.htm.
Keeton-Strayhorn, Carole (2005). Capital Metro TPR Report - Chapter 2, Management
Accountability. Retrieved November 26, 2005, from www.window.state.tx.
us/tpr/capnet/chpt2.htm.
McCracken, M. E. (2005). Capital budgeting. Retrieved November 14, 2005, 2005 from
http://teachmefinance.com/capitalbudgeting.html.
MoneyInstructor.Com, (2005). Capital Budgeting, understanding basic finance and
Capital budgeting. Retrieved from www.moneyinstructor.com.
Wikipedia, (2005). Corporate Finance. Retrieved November 19, 2005 from
http://en.wikipedia.org/wiki/Corporate_finance.
Williamson-Duncan, (2005) Capital Budgeting: eight steps. Retrieved November 26,
2005, from: Duncan Williamson: Capital Budgeting capbudint.html.