Right from starting a business to planning major operational expansions and growth, business capital is a must. Accomplishing any major business expansion requires substantial capital or fixed assets. This is where the capital budgeting process becomes essential. Management uses capital budgeting to plan expenditures on fixed assets.
The capital budgeting process helps the company’s management determine which long-term strategy it can invest in to achieve its growth goals. Read on to understand the capital budgeting process, its objectives, and how capital budgeting works for your organization.
Introduction to the Capital Budgeting Process
Before going on to the capital budgeting process, let us first understand what business capital is. The funds available to be invested in a business either as equity or debt is known as capital. Capital is a limited resource. Managers, therefore, must make careful choices about when and where to invest capital to ensure that it creates value for the company.
The capital budgeting process is defined as the process by which a business determines which fixed asset purchases or project investments are acceptable and which are not. Ideally, businesses would pursue any project or opportunity that enhances the profit or shareholder’s value. Due to the limited availability of capital for new projects, management resorts to capital budgeting methods to determine which project will yield the highest return over an applicable period.
Capital budgeting is a powerful financial budget management tool that can be used to analyze investment in a capital asset, a new project, a new company, or even an acquisition of a company. This analysis provides inputs for justifying the investment to relevant stakeholders. Capital budgeting is the process of analyzing whether significant monetary expenditures add value to the business.
Capital budgeting process steps are followed by businesses when they want to evaluate an investment or expenditure with a higher dollar amount. Capital budgeting is the process of determining whether to invest in specific funds, add new funds, or the process of removing, replace, or purchase new fixed assets.
The CapEx process involves decisions involving decisions about buildings, equipment, land, research, and development. Essentially the steps in the capital budgeting process focus on the comparison of the cost/investment in a project against the cash flows generated by the same venture. When the value of the future cash flows exceeds the cost/investment, then the new venture is said to create potential value for the business and it makes sense to pursue the project to extract its value.
More often than not finance or business managers go by their gut feeling to make capital budget investments. Some others simply make a note of some ideas to prepare a back-of-the-envelope financial analysis. Making capital budgeting based on such analyses alone is a recipe for financial disaster. Capital budgeting decisions cannot be taken lightly, they require complete analysis and evaluation of the costs and outcomes.
When is Capital Budgeting Used?
The expense approval process for budgeting is applicable for short-term and smaller investments. Capital budgeting on the other hand is applicable for high-value projects that can benefit the firm in the long run.
Capital budgeting examples include the acquisition of a new company, expansion of business operations, and purchase of large-scale equipment for the business. While making capital budgeting approval decisions, it must be borne in mind that the chosen project will not only pay back the original cost of investment but also generate substantial profits.
The projects and investments that require capital budgeting are often on the wish list of the company. Companies usually consider these investments over time as they expand their business operations.
The capital budget management process involves thoroughly analyzing cash inflows and outflows to determine if the expected returns meet a set benchmark. The main methods adopted by capital budgeting are discounted cash flow, throughput analyses, and payback.
What are the characteristics of capital budgeting?
➤ There is a long duration between the initial investment and expected outcomes
➤ The project involves high risk
➤ All projects require large capital
➤ Estimated profits are large
➤ It is a fixed investment in the long run
➤ The investment made in the project determines the profitability of the company
Objectives of Capital Budgeting
Understanding the capital budgeting process is simplified by flashcards offered by Quizlet. Quizlet uses flashcards to explain the capital budgeting process.
What does capital budgeting focus on?
The following points are the main objectives of capital budgeting.
Capital expenditure control – Estimating the cost of investment enables companies to control and manage the required capital expenditures.
Selecting profitable projects – Choosing the most profitable projects from multiple options can be done with the help of capital budgeting
Identification of the source of funds – Locating and selecting the most viable and apt source of funds for long-term capital investment can be done with capital budgeting. Various costs like costs of borrowing and the cost of expected profits can be determined through capital budgeting.
Steps in the Capital Budgeting Process
Following capital budgeting process steps enable businesses to make informed capital budgeting decisions. There are 6 steps in the capital budgeting process.
1. Identifying the investment opportunities
The first step in the capital budgeting process is identifying investment opportunities. Once the opportunities are identified, the company’s capital budgeting committee identifies the expected sales. The investment opportunities that are aligned with the sales targets are identified.
Identification of the best investment opportunities requires regular monitoring of the external environment to understand the investment opportunities better. The corporate strategy is based on the SWOT analysis and suggestions from employees on investment opportunities.
2. Gathering investment proposals
Once the investment opportunities are identified, the next step is to collect investment proposals. Proposals are evaluated by various authorized persons in the organization before submitting them to the capital budgeting committee in order to ensure that bids are given according to requirements.
The investment proposals are classified into categories such as expansion, welfare investment, replacement, etc. Classifying the proposals aids decision-making and facilitates budgeting and control.
3. Deciding on projects for capital budgeting
This step involves executives who will be deciding which investments need to be made from the available investment opportunities. The sanctioning power open to them influences the decision-making process.
4. Preparation and Appropriation in Capital Budgeting
Once the decision is made on the investments for capital budgeting, the investment outlays are classified into higher and smaller investments. When the value of an investment is low and approved at the lower management level, then for getting speedy actions they are generally covered with blanket appropriations.
5. Implementation of Capital Budgeting
Once all of the preparatory steps are completed, the investment proposals are implemented. The investment proposals are converted into concrete projects. The implementation phase poses several challenges to the management personnel. Successful implementation requires adequate formulation of the project and the use of the responsibility accounting principle. Several network techniques like the critical path method (CPM) and program evaluation and review technique (PERT) can be used in implementing capital budgeting projects.
6. Performance review
The last and most important step in capital budgeting is a review of the performance of capital budgeting projects. For this, management must compare the actual results with the projected results. This comparison must be done when operations get stabilized.
How does Capital Budgeting Work?
Investment and financial commitments are an integral part of capital budgeting. While companies would like to take up all the projects that maximize the benefits of stakeholders, they also understand that there is a limitation on the budget allocation for each project. Therefore, utilizing capital budgeting strategies to assess the initiatives that provide the highest return.
Companies use capital budgeting to measure any option contract’s long-term monetary and fiscal profit margins. Capital budgeting projects are accepted or rejected according to different valuation methods used by different businesses.
The calculation for capital budgeting is sometimes done using internal rate of return (IRR) and payback period (PB) methods, sometimes net present value (NPV) is used for calculations. If all 3 types of calculations point in the same direction, managers can be most confident in their analysis.
When a company is dealing with capital budgeting, the decision determines whether or not a project is profitable or not. The common methods used for selecting projects are listed below:
1. Payback period (PB)
The payback period refers to the time taken by the proposed project to generate enough income to cover the initial investment. The project that gives the quickest feedback is chosen by the company.
The formula for calculation – Payback period = Initial cash investment
Annual cash flow
Although the payback period method is easy and efficient, the Payback method cannot be called optimum as it does not consider the time value of money. The cash flows at earlier stages could be better than the ones coming in at later stages. The company may encounter two projections with the same payback period, where one depicts higher cash flow in earlier stages. In such cases, Payback period calculations may not be appropriate.
2. Internal Rate of Return (IRR)
This method is used when the NPV is zero. When the cash inflow rate equals the cash outflow rate, the NPV is zero. The IRR method considers the time value of money for calculating capital budgeting. It follows the rule that if the IRR value is more than the average cost of the capital, then the company accepts the project, else it rejects it. The project offering the highest IRR is selected for capital budgeting.
3. Net Present Value (NPV)
Evaluating capital investment is what the NPV method helps companies with. Inconsistencies in cash flows may occur over time. The cost of capital is used to discount these inconsistencies. The value of the inflows over current outflows decides whether the project is accepted or rejected.
The NPV method considers the time value of money in its calculations and attributes it to the company’s objective of maximizing profits for its owners. The capital cost factors in the cash flow for the entire lifespan of the product and the risks associated with such a cash flow are considered in this formula.
4. Profitability Index
This method calculates the ratio of the present value of the cash inflows to the initial investment. The Profitability Index value of less than 1.0 indicates lower cash inflows compared to the initial investment. Projects that present a profitability index value greater than 1 present better cash flows, and therefore, will be accepted.
Capital Budgeting Analysis
To understand capital budgeting analysis better, let us consider an example. A logistics company XYZ plans to purchase a new truck for making local, short-haul deliveries. The usage of the truck is for 4 years, after which the company plans to sell it at a fair resale price. The proceeds from the resale would be used as the down payment for a more modern replacement truck. The estimated weighted average cost of the capital being invested (WACC) is 14%.
Step 1 – Determining the Total Amount of the Investment
The total investment represents the total cost of the asset being acquired, or the total investment necessary to fund the project. For XYZ company, the total investment comprises of
➤ Purchase base Model Truck
➤ Add Cargo Lift/Paint Logo
➤ Sales Tax
➤ Registration and Other costs
Step 2 – Determining the Cash Flows that the Investment will return
The net cash flow that the investment will return is calculated at this step. The net cash flow must not be confused with the accounting earnings. The projection of the income statement will give an indication of the investment cash flows.
Step 3 – Determining the residual/terminal value
Capital budgeting requires a finite number of future cash flows. In this example, the company intends to sell the truck in 4 years. The residual value is equal to the net sales proceeds to be received from the disposition of the asset. Some investments do not have a projected ending. Another way to allow continuing operations is to calculate the terminal value. A terminal value assumes that the cash flow in the final year of projection will continue at the same level into the future.
Step 4 – Calculating the annual cash flows of the investment
Calculating the annual cash flows is completed by incorporating the values derived in steps 1 to 3 into a timeline. Cash outflows are shown as negative values and cash inflows are shown as positive values. Aligning cash flows with periods in which they occur and adding each period’s cash flows together helps determine the annual cash flow amounts.
Step 5 – Calculating the NPV of the cash flows
The NPV is the sum of the PV of each year’s cash flow. The formula for calculating the PV is given below:
PV of cash flow = Cash flow/ (1+Discount rate) year
When the calculated NPV is positive, the project will return value in excess of the investment amount and is worth pursuing further.
Step 6 – Running a sensitivity analysis
A positive NPV on a base case projection indicates that the project is worth pursuing. However, this alone should not be the sole basis for proceeding with the investment. After getting a positive NPV value, management must perform a stress test of the work by considering “what if” questions.
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Common Applications of Capital Budgeting
What business decisions should be based on capital budgeting? Capital budgeting can be used to analyze most of the major investment decisions taken by the business. From starting a new business to purchasing business equipment to investing in expanding operations – all decisions can be based on capital budgeting analysis. Common applications of capital budgeting are:
When acquiring a Portfolio of Assets – Capital budgeting analysis helps in making the right decisions on acquiring a portfolio of assets. The decision is based on the asking price of the portfolio, cash flows from the loans, return rate, and NPV. Capital budgeting analysis enables management to know what the ROI would be on the purchase at alternative prices and the absolute maximum price that could be paid and still receive an acceptable ROI.
When operations for new ventures are projected – capital budgeting techniques help determine the financial feasibility of the new venture.
Limitations of Capital Budgeting
Although the capital budgeting process is extremely useful in providing insights into the future aspects of a business, it cannot be considered a comprehensive method. The common limitations of capital budgeting include:
Cash flows – It’s a simple technique that determines if an enhanced value of the project justifies the required investment. The problem could be the method of estimation itself. All the upfront costs or future revenue are only estimated values. An overestimation or an underestimation could ultimately affect the business adversely.
Time value – The payback period of capital budgeting holds a lot of relevance, especially for small businesses. As per this analysis, businesses need to only pay back within a pre-decided timeframe. The time value of money is not determined. Capital budgeting does not take into account the fact that the same amounts of money will have different values at different points in time.
Discount rates – The accounting time for the time value of money is done either by paying interest, borrowing money, or using one’s own money. Discount rates must be considered in these calculations. Accurate estimation and calculation of discount rates is a cumbersome process. Even if it is accurately determined, other factors like varying interest rates could hamper future cash flows.
Time horizon – Capital budgeting is a long-term process spanning several years. Shorter duration forecasts can be accurately determined, but longer duration estimates are often error-prone. An expanded time horizon, therefore, could be a potential problem while calculating values with capital budgeting.
Capital Budgeting and Workflow Automation
During capital budgeting, it is essential to have a set of policies, procedures, and rules that need to be followed to ensure that all values are accurately calculated. For some businesses finding the right time and people with domain expertise in capital budgeting is a challenging proposition. Workflow automation comes to the rescue of such businesses. Using workflow automation solutions like Cflow can simplify the process of performing complex calculations in capital budgeting.
Simplifying the capital budgeting process helps reduce the margin of human error and enables more accurate projections. Cflow can help automate key business workflows like capital budgeting with easy-to-use visual tools. The drag-and-drop user interface accelerates the sequencing of all the tasks associated with capital budgeting, thereby, cutting down process times significantly.
The capital budgeting process is essential for long-term investments made by organizations. Various capital budgeting techniques and capital budgeting examples have been listed in the above sections. The most effective way to simplify the process and ensure more accurate outcomes is to go for workflow management. An intuitive workflow automation solution like Cflow can automate the capital budgeting process to save time and money. The software offers several features that management can use to make their budgeting decisions more effective. To explore Cflow, sign up for the free trial today.
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