Definition of Capital Budgeting

Capital budgeting is the process that a business uses to determine which

proposed fixed asset purchases it should accept, and which should be declined. This
process is used to create a quantitative view of each proposed fixed asset investment,
thereby giving a rational basis for making a judgment.

Capital Budgeting Methods

There are a number of methods commonly used to evaluate fixed assets unde r a formal
capital budgeting system. The more important ones are:

 Net present value analysis. Identify the net change in cash flows associated with a fixed
asset purchase, and discount them to their present value. Then compare all proposed
projects with positive net present values, and accept those with the highest net present
values until funds run out.
 Constraint analysis. Identify the bottleneck machine or work center in a production
environment and invest in those fixed assets that maximize the utilization of the
bottleneck operation. Under this approach, you are less likely to invest in areas
downstream from the bottleneck operation (since they are constrained by the
bottleneck operation) and more likely to invest upstream from the bottleneck (since
additional capacity there makes it easier to keep the bottleneck fully supplied with
inventory).
 Payback period. Determine the period required to generate sufficient cash flow from a
project to pay for the initial investment in it. This is essentially a risk measure, for the
focus is on the period of time that the investment is at risk of not being returned to the
company.
 Avoidance analysis. Determine whether increased maintenance can be used to prolong
the life of existing assets, rather than investing in replacement assets. This analysis can
substantially reduce a company's total investment in fixed assets.

The Importance of Capital Budgeting

The amount of cash involved in a fixed asset investment may be so large that it could
lead to the bankruptcy of a firm if the investment fails. Consequently, capital budgeting
is a mandatory activity for larger fixed asset proposals. This is less of an issue for
smaller investments; in these latter cases, it is better to streamline the capital
budgeting process substantially, so that the focus is more on getting the investments
made as expeditiously as possible; by doing so, the operations of profit centers are not
hindered by the analysis of their fixed asset proposals.

Introduction
Capital budgeting is the process that companies use for decision making on capital projects—
those projects with a life of a year or more. This is a fundamental area of knowledge for
financial analysts for many reasons.

 First, capital budgeting is very important for corporations. Capital projects, which make
up the long-term asset portion of the balance sheet, can be so large that sound capital
budgeting decisions ultimately decide the future of many corporations. Capital decisions
cannot be reversed at a low cost, so mistakes are very costly. Indeed, the real capital
investments of a company describe a company better than its working capital or capital
structures, which are intangible and tend to be similar for many corporations.
 Second, the principles of capital budgeting have been adapted for many other corporate
decisions, such as investments in working capital, leasing, mergers and acquisitions, and
bond refunding.
 Third, the valuation principles used in capital budgeting are similar to the valuation
principles used in security analysis and portfolio management. Many of the methods
used by security analysts and portfolio managers are based on capital budgeting
methods. Conversely, there have been innovations in security analysis and portfolio
management that have also been adapted to capital budgeting.
 Finally, although analysts have a vantage point outside the company, their interest in
valuation coincides with the capital budgeting focus of maximizing shareholder value.
Because capital budgeting information is not ordinarily available outside the company,
the analyst may attempt to estimate the process, within reason, at least for companies
that are not too complex. Further, analysts may be able to appraise the quality of the
company’s capital budgeting process—for example, on the basis of whether the
company has an accounting focus or an economic focus.

This reading is organized as follows: Section 2 presents the steps in a typical capital
budgeting process. After introducing the basic principles of capital budgeting in Section 3, in
Section 4 we discuss the criteria by which a decision to invest in a project may be made.
Learning Outcomes
The candidate should be able to:

a. describe the capital budgeting process and distinguish among the various categories of
capital projects;
b. describe the basic principles of capital budgeting;
c. explain how the evaluation and selection of capital projects is affected by mutually
exclusive projects, project sequencing, and capital rationing;
d. calculate and interpret net present value (NPV), internal rate of return (IRR), payback
period, discounted payback period, and profitability index (PI) of a single capital
project;
e. explain the NPV profile, compare the NPV and IRR methods when evaluating
independent and mutually exclusive projects, and describe the problems associated with
each of the evaluation methods;
f. describe expected relations among an investment’s NPV, company value, and share
price.

Summary
Capital budgeting is the process that companies use for decision making on capital projects—
those projects with a life of a year or more. This reading developed the principles behind the
basic capital budgeting model, the cash flows that go into the model, and several extensions
of the basic model.

 Capital budgeting undergirds the most critical investments for many corporations—their
investments in long-term assets. The principles of capital budgeting have been applied to
other corporate investing and financing decisions and to security analysis and portfolio
management.
 The typical steps in the capital budgeting process are: 1) generating ideas, 2) analyzing
individual proposals, 3) planning the capital budget, and 4) monitoring and post-
auditing.
 Projects susceptible to capital budgeting process can be categorized as: 1) replacement,
2) expansion, 3) new products and services, and 4) regulatory, safety and environmental.
 Capital budgeting decisions are based on incremental after-tax cash flows discounted at
the opportunity cost of funds. Financing costs are ignored because both the cost of debt
and the cost of other capital are captured in the discount rate.
 The net present value (NPV) is the present value of all after-tax cash flows,
or NPV=n∑t=0CFt(1+r)tNPV=∑t=0nCFt(1+r)t where the investment outlays are
negative cash flows included in the CF t s and where r is the required rate of return for
the investment.
 The IRR is the discount rate that makes the present value of all future cash flows sum to
zero. This equation can be solved for the
IRR:n∑t=0CFt(1+IRR)t=0∑t=0nCFt(1+IRR)t=0
 The payback period is the number of years required to recover the original investment in
a project. The payback is based on cash flows.
 The discounted payback period is the number of years it takes for the cumulative
discounted cash flows from a project to equal the original investment.
 The average accounting rate of return (AAR) can be defined as
follows:AAR=Average net incomeAverage book valueAAR=Average ne
t incomeAverage book value
 The profitability index (PI) is the present value of a project’s future cash flows divided
by the initial
investment:PI=PV of future cash flowsInitial investment=1+NPVInitial i
nvestmentPI=PV of future cash flowsInitial investment=1+NPVInitial i
nvestment
 The capital budgeting decision rules are to invest if the NPV > 0, if the IRR > r, or if the
PI > 1.0 There are no decision rules for the payback period, discounted payback period,
and AAR because they are not always sound measures.
 The NPV profile is a graph that shows a project’s NPV graphed as a function of various
discount rates.
 For mutually exclusive projects that are ranked differently by the NPV and IRR, it is
economically sound to choose the project with the higher NPV.
 The “multiple IRR problem” and the “no IRR problem” can arise for a project with
nonconventional cash flows—cash flows that change signs more than once during the
project’s life.
 The fact that projects with positive NPVs theoretically increase the value of the
company and the value of its stock could explain the popularity of NPV as an evaluation
method.
 Definition of Capital Budgeting
Capital budgeting is a process used by companies for evaluating and ranking potential capital
expenditures or investments that are significant in amount. A few examples of capital
expenditures include:
 Purchase of new equipment
 Rebuilding existing equipment
 Purchasing delivery vehicles
 Constructing additions to buildings
Examples of Capital Budgeting Calculations
Capital budgeting usually involves the following calculations for each project:

 Future accounting profit by period

 Future cash flows by period
 Present value of the cash flows by discounting them with an appropriate interest rate
 The number of years it takes for a project's cash flow to pay back the initial cash investment
 An assessment of risk along with the urgency of the project

What is a non-discount method in capital budgeting?

A non-discount method of capital budgeting does not explicitly consider the time value of
money. In other words, each dollar earned in the future is assumed to have the same value as
each dollar that was invested many years earlier. The payback method is one of the
techniques used in capital budgeting that does not consider the time value of money.
The payback method simply computes the number of years it will take for an investment to
return cash equal to the amount invested. For example, if an investment of $100,000 is made
and it generates cash of $50,000 for two years followed by $10,000 per year for four
additional years, its payback is two years ($50,000 + $50,000). If another investment of
$100,000 generates cash of $20,000 per year for two years and then provides cash of $40,000
per year for six additional years, its payback is approximately 3.5 years ($20,000 + $20,000 +
$40,000 + 0.5 times $40,000).

As you can see in the examples, payback only answers one question: How long before the
cash invested is returned? Payback does not address which investment is more profitable.
Payback not only ignored the time value of money, it ignored all of the cash received after
the payback period.
The accounting rate of return or return on investment (ROI) are two more examples of
methods used in capital budgeting that does not involve discounting future cash amounts.
To overcome the shortcomings of payback, accounting rate of return, and return on
investment, capital budgeting should include techniques that consider the time value of
money. Two of these methods include (1) the net present value method, and (2) the internal
rate of return calculation. Under these techniques, the future cash flows are discounted. This
means that each dollar in the distant future will be less valuable than each dollar in the near
future, and both of these will have less value than each dollar invested in the present.

What is the difference between financial accounting

and management accounting?

Definition of Financial Accounting

Financial accounting has its focus on the financial statements which are distributed to
stockholders, lenders, financial analysts, and others outside of a corporation or other
organization. Because of the many users, the financial statements must comply with the
generally accepted accounting principles, known as GAAP or US GAAP.
Definition of Managerial Accounting
Managerial accounting is focused on assisting management in the operation of the company.
This will include analyzing a company's costs, assisting in financial decisions, profit
planning, calculating break-even points, capital budgeting, and calculating the costs of
existing products in order to value the company's inventory and to determine the cost of
goods sold (both to be used on the financial statements).