1. INTRODUCTION
Capital budgeting is the process that companies use for decision making on capital projects — 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.
2. THE CAPITAL BUDGETING PROCESS
The specific capital budgeting procedures that managers use depend on their level in the organization,
the size and complexity of the project being evaluated, and the size of the organization. The typical steps
in the capital budgeting process are as follows:
Step one, generating ideas: Investment ideas can come from anywhere, from the top or the bottom of
the organization, from any department or functional area, or from outside the company. Generating
good investment ideas to consider is the most important step in the process.
Step two, analyzing individual proposals: This step involves gathering the information to forecast cash
flows for each project and then evaluating the project’ s profitability.
Step three, planning the capital budget: The company must organize the profitable proposals into a
coordinated whole that fits within the company’ s overall strategies, and it also must consider the
projects’ timing. Some projects that look good when considered in isolation may be undesirable
strategically. Because of financial and real resource issues, scheduling and prioritizing projects are
important.
Step four, monitoring and post auditing: In a post audit, actual results are compared to planned or
predicted results, and any differences must be explained. For example, how do the revenues, expenses,
, and cash flows realized from an investment compare to the predictions? Post auditing capital projects is
important for several reasons.
Companies often put capital budgeting projects into rough categories for analysis. One
such classification is as follows:
1. Replacement projects: These are among the easier capital budgeting decisions. If a piece of
equipment breaks down or wears out, whether to replace it may not require careful analysis. If the
expenditure is modest and if not investing has significant implications for production, operations, or
sales, it would be a waste of resources to overanalyze the decision. Just make the replacement. Other
replacement decisions involve replacing existing equipment with newer, more efficient equipment or
perhaps choosing one type of equipment over another. These replacement decisions are often
amenable to very detailed analysis, and you might have a lot of confidence in the final decision.
2. Expansion projects: Instead of merely maintaining a company’ s existing business activities,
expansion projects increase the size of the business. These expansion decisions may involve more
uncertainties than replacement decisions, and they should be more carefully considered.
3. New products and services: These investments expose the company to even more uncertainties than
expansion projects. These decisions are more complex and will involve more people in the decision -
making process.
4. Regulatory, safety, and environmental projects: These projects are frequently required by a
governmental agency, an insurance company, or some other external party. They may generate no
revenue and might not be undertaken by a company maximizing its own private interests. Often, the
company will accept the required investment and continue to operate. Occasionally, however, the cost
of the regulatory, safety, or environmental project is sufficiently high that the company would do better
to cease operating altogether or to shut down any part of the business that is related to the project.
5. Other: The preceding projects are all susceptible to capital budgeting analysis, and they can be
accepted or rejected using the net present value (NPV) or some other criterion.
Some projects escape such analysis. These are either pet projects of someone in the company (such as
the CEO buying a new aircraft) or so risky that they are difficult to analyze by the usual methods (such as
some research and development decisions).
3. BASIC PRINCIPLES OF CAPITAL BUDGETING
Capital budgeting has a rich history and sometimes employs some sophisticated procedures.
Fortunately, capital budgeting relies on just a few basic principles and typically uses the following
assumptions:
1. Decisions are based on cash flows: The decisions are not based on accounting concepts, such as net
income. Furthermore, intangible costs and benefits are often ignored because, if they are real, they
should result in cash flows at some other time.
2. Timing of cash flows is crucial: Analysts make an extraordinary effort to detail precisely when cash
flows occur.
Capital budgeting is the process that companies use for decision making on capital projects — 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.
2. THE CAPITAL BUDGETING PROCESS
The specific capital budgeting procedures that managers use depend on their level in the organization,
the size and complexity of the project being evaluated, and the size of the organization. The typical steps
in the capital budgeting process are as follows:
Step one, generating ideas: Investment ideas can come from anywhere, from the top or the bottom of
the organization, from any department or functional area, or from outside the company. Generating
good investment ideas to consider is the most important step in the process.
Step two, analyzing individual proposals: This step involves gathering the information to forecast cash
flows for each project and then evaluating the project’ s profitability.
Step three, planning the capital budget: The company must organize the profitable proposals into a
coordinated whole that fits within the company’ s overall strategies, and it also must consider the
projects’ timing. Some projects that look good when considered in isolation may be undesirable
strategically. Because of financial and real resource issues, scheduling and prioritizing projects are
important.
Step four, monitoring and post auditing: In a post audit, actual results are compared to planned or
predicted results, and any differences must be explained. For example, how do the revenues, expenses,
, and cash flows realized from an investment compare to the predictions? Post auditing capital projects is
important for several reasons.
Companies often put capital budgeting projects into rough categories for analysis. One
such classification is as follows:
1. Replacement projects: These are among the easier capital budgeting decisions. If a piece of
equipment breaks down or wears out, whether to replace it may not require careful analysis. If the
expenditure is modest and if not investing has significant implications for production, operations, or
sales, it would be a waste of resources to overanalyze the decision. Just make the replacement. Other
replacement decisions involve replacing existing equipment with newer, more efficient equipment or
perhaps choosing one type of equipment over another. These replacement decisions are often
amenable to very detailed analysis, and you might have a lot of confidence in the final decision.
2. Expansion projects: Instead of merely maintaining a company’ s existing business activities,
expansion projects increase the size of the business. These expansion decisions may involve more
uncertainties than replacement decisions, and they should be more carefully considered.
3. New products and services: These investments expose the company to even more uncertainties than
expansion projects. These decisions are more complex and will involve more people in the decision -
making process.
4. Regulatory, safety, and environmental projects: These projects are frequently required by a
governmental agency, an insurance company, or some other external party. They may generate no
revenue and might not be undertaken by a company maximizing its own private interests. Often, the
company will accept the required investment and continue to operate. Occasionally, however, the cost
of the regulatory, safety, or environmental project is sufficiently high that the company would do better
to cease operating altogether or to shut down any part of the business that is related to the project.
5. Other: The preceding projects are all susceptible to capital budgeting analysis, and they can be
accepted or rejected using the net present value (NPV) or some other criterion.
Some projects escape such analysis. These are either pet projects of someone in the company (such as
the CEO buying a new aircraft) or so risky that they are difficult to analyze by the usual methods (such as
some research and development decisions).
3. BASIC PRINCIPLES OF CAPITAL BUDGETING
Capital budgeting has a rich history and sometimes employs some sophisticated procedures.
Fortunately, capital budgeting relies on just a few basic principles and typically uses the following
assumptions:
1. Decisions are based on cash flows: The decisions are not based on accounting concepts, such as net
income. Furthermore, intangible costs and benefits are often ignored because, if they are real, they
should result in cash flows at some other time.
2. Timing of cash flows is crucial: Analysts make an extraordinary effort to detail precisely when cash
flows occur.
