Capital budgeting is the decision-making process that establishes the goals and criteria for planning and investing a firm’s resources in fixed assets or long-term projects. Capital budgeting normally includes the evaluation of projects like land, building, facilities, equipment, vehicle fleets, and so on.
Capital budgeting is important for the following reasons:
1. The size of the investments. As discussed throughout this book, the key function of a financial officer is to maximize the value of the company. Allocating large amounts of capital without proper investigation and analysis would expose the company to certain risks and may result in the devaluation of ...view middle of the document...
For example, investing in an MIS department and expanding warehouse are two independent projects.
2. Mutually Exclusive Projects
Mutually exclusive projects are those that have similar functions and accepting one will exclude others from consideration. For example, building a factory or office on the same piece of land means making a mutually exclusive decision. Another example is the question of location for project. Should it be in location “A” or location “B”?
Classification of Investments
Long-term investments are classified in three ways:
3. New venture
Expansion means investing capital in something that a firm is already doing in order to increase output. The main reason for expansion is to respond to an increase in demand for the firm’s product or services. In this case, funds are usually invested in working capital and in similar equipment the company uses.
Replacement is simply replacing existing equipment with new. There are many reasons for this action, including worn-out equipment, assets needing major repairs or replacement, or changes in technology that require new, more efficient equipment.
3. New Venture
This simply means expanding into new product lines or markets.
Steps in Capital Budgeting
There are five steps in capital budgeting process:
1. Identification of the project
Each firm should establish a procedure through which new opportunities will be identified.
After the projects have been identified, they need to be analyzed. This step is the subject of this chapter.
The selection process should include two steps:
a. Setting the criteria for accepting or rejecting a particular project.
b. Applying the criteria in reviewing each project.
Once the project has been selected, it must be implemented. This step includes raising appropriate capital, purchasing equipment, hiring, and so on.
After the completion, the project must be reevaluated. Management determines if the original assumptions were met throughout the implementation phase. Any major deviation should be carefully analyzed.
In valuation we have learned in order to evaluate any project we need to know three factors:
a. Cash Flows
b. Timing of Cash Flows
c. Required Rate of Return (in capital budgeting we call this rate the cost of capital which will be discussed later)
Determining these factors, we use the following techniques to analyze a project:
a. Payback Period (PP)
b. Net Present Value (NPV)
c. Profitability Index (PI)
d. Internal Rate of Return (IRR)
The payback period is a length of time needed in order to cover the total investment in the project. The payback period is...