CAPITAL BUDGETING
April 27, 2010
Any prudent financial manager will be concerned as to how efficiently he can allocate funds at his disposal to various ventures available in the investments market. To a company, investment should be a continuous process if it is to survive in the future. It is important because it affects:
1. The size of the company
2. The risk of the finance invested
3. The company’s growth prospects.
A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a period
of time in the future. An operating expenditure is an outlay of funds resulting in benefits received within one year. Fixed assets outlays are capital expenditures although not all capital expenditures are classified as fixed assets. The basic motives for capital expenditures are:
§ To obtain some other less tangible benefit over a long period e.g. R & D, management consulting and advertising
Capital expenditure decisions refer to all investment decisions in a firm and require careful planning of the company’s funds. This is referred to as capital budgeting.
Capital budgeting is the process of planning expenditures on assets whose cash flows are expected to extend beyond one year. Capital budgeting decisions generally refer to either replacement decisions or expansion decisions. Replacement decisions involve the purchase of capital assets to take the place of existing assets to maintain or improve existing operations. Expansion decisions involve the purchase of capital projects and adding them to existing assets to increase existing operations. The investment decisions call for budgeting of all investible finances in areas such as:
i) Purchase of new assets
ii) Research and development
iii) Development of new product lines
iv) Expansion and modernization of existing plants and machinery so as to meet current needs of the company.
All these decisions are long-term and are expected to generate benefits for a long period in the future.
Some of the capital budgeting decisions involve independent projects while others involve mutually exclusive projects. Independent projects are projects whose cash flows are not affected by decisions made about other projects. Mutually exclusive projects are a set of projects in which the acceptance of one project means the rejection of the others.
1. Capital budgeting decisions define a company’s strategic direction.
If viable, they have the effect of increasing the value of a company’s shares in the stock exchange and hence the shareholders’ investment if they result in viable ventures.
They expose a company’s money to a risk depending on the nature of the investment and, if badly made, they can lead to a company’s receivership and consequently liquidation.
2. The results of capital budgeting decisions are long term and make the firm lose some of its flexibility. The decisions, once taken, are irreversible and therefore call for prudent management attitudes towards all investment decisions.
3. Timing is very important since capital assets must be available when they are needed.
Capital projects are developed by the firm using the following procedures:
1. Proposal generation. Proposals are made at all levels within a business organization and are reviewed by the finance personnel. Proposals requiring huge cash outlays are carefully scrutinized than less costly ones.
2. Review and analysis. Formal reviewand analysis is performed to assess the appropriateness of proposals and evaluate their economic viability. Once the analysis is complete, a summary report is submitted to decision makers.
3. Decision making. Firms typically delegate capital expenditure decision making on the basis of amount limits. Generally, the board of directors must authorize expenditures beyond certain amounts. Often plant managers are given authority to make decisions necessary to keep the production work moving.
4. Implementation. Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored, actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones.
NB: Each procedure is important. However, review and analysis and decision making (procedure 2 & 3) consume the majority of time and effort.
STEPS IN THE CAPITAL BUDGETING PROCESS
1. Determine the cost of the project.
2. Estimate the expected cash flows from the project, including the salvage value of the asset at the end of its expected useful life.
3. Estimate the riskiness of the projected cash flows.
4. Determine the appropriate rate of return to use to discount the cash flows
5. Find the present value of the expected cash flows to obtain an estimate of the asset’s value to the firm.
6. Compare the present value of the expected cash inflows with the investment or cost required to acquire the asset; If the PV of the cash flows exceeds the cost, the project should be accepted. Otherwise, it should be rejected.
Alternatively, the expected rate of return on the project can be calculated and if this rate of return exceeds the rate of return considered appropriate for the project, it should be accepted.
If a firm identifies or creates an investment opportunity with a present value greater than its cost, the value of the firm will increase. The more effective the firm’s capital budgeting procedures, the higher the price of its stock.
CAPITAL RATIONING
This can be defined as that situation where a business is constrained by both external and internal factors such that it cannot manage to raise necessary funds from the financial markets to invest in all viable ventures available to such a company from the investment markets.
Under such a situation it will be necessary for such a company to select projects as follows:
Rank investments according to their profitability using PI or IRR
Choose projects according to their rank, beginning with the most highly ranked ventures going downward until the finances available are exhausted.
The main objective in capital rationing should be to maximize the company’s profits subject to budget constraints.
1. Economic conditions prevailing may not be the best eg. a recession which may limit the company’s ability to raise finance in particular debt finance from capital markets
2. If there are conditions where floatation issues are expensive that it would be uneconomical to issue shares or debentures
3. If there are credit controls or a credit squeeze in the lending market that make it difficult for a company to raise debt finance in the market
4. Size of the company may also limit the company’s ability to raise finance eg a small company may be seen as a credit risk or lack the assets to pledge as security for loans
5. If the company is already highly leveraged thus hindering it from raising more debt finance
6. If company’s owners’ do not want to dilute their shareholding or lose control by issuing more shares or borrowing heavily, which may cause a dilution in their shareholding thus the company resorts to capital rationing in order to preserve the owners’ control.
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