Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.
In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, corporations, and governments. In addition, the central bank requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers. But even if a bank were to extend unlimited loans to a company, the management of that company would need to consider the impact that increasing loans would have on the overall cost of financing.
In reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. One might argue that a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders. In other words, as the number of shares of a company increases, the company ownership of the individual stockholder may proportionally decrease.
The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital.
Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.
Note: Capital budgeting is investment decision-making as to whether a project is worth undertaking. Capital budgeting is basically concerned with the justification of capital expenditures. Current expenditures are short-term and are completely written off in the same year that expenses occur. Capital expenditures are long-term and are amortized over a period of years.
Capital budgeting decisions involve evaluating the profitability of the firm’s potential investments in new property, plant and equipment. Managers face two types of situations when they do this. The first situation occurs when the manager is given two or more ways to achieve the same result e.g. deciding whether it is more profitable to replace a worn equipment with a machine that has to be replaced every five years or to buy a higher priced machine that will last ten years. The second situation occurs when managers have to evaluate the profitability of a potential investment e.g. evaluating the profitability of investing in a plant that will last 30 years in order to support an expected increase in sales.
Differences in the length of investments and the amount and timing of costs and benefits from each alternative solution mean that the manager needs a decision procedure that:
- Fully accounts for the timing and amount of capital required for the investment.
- Fully accounts for the timing and amount of added benefits likely to result over the life of the investment
- Can objectively evaluate capital budgeting decisions so management can maximize long-term profits.
Capital budgeting decisions
A good capital investment has four characteristics
- It provides positive long-term net profit to the firm
- When selecting among alternative capital budgeting solutions, it is the investment alternative that provides the highest long-term net profit to the firm
- It provides benefits sooner than later
- It provides the lowest risk
There are two distinct approaches to managing a firm’s annual investments in capital projects (i.e., in long-lived assets).
- Fixed capital budget: First, management can decide to spend a budget of no more than Shs.X for that purpose- so called “capital budget”- and then look for the most profitable set of capital acquisitions that fall within this overall budget constraint. If a firm is assumed to have set a capital budget of Shs. 100 million for the coming year then the firm will then do two things: First, it will explore individual proposed projects one by one to see whether, viewed by itself, a given acquisition would make the firm’s owners richer or poorer. If richer, the project is a viable candidate, if poorer, it is rejected. If neither richer nor poorer, it is a matter of indifference. Once the set of profitable projects has been identified, the firm selects the most profitable project that can be accommodated within its predetermined capital budget.
- Flexible capital budget: Economists do not like the fixed capital-budget approach because it may lead management to reject projects that would have made the firm’s owners richer, but did not fit within the predetermined capital budget. Therefore, economists would recommend that the firm accept all profitable projects (that make the firm’s owners richer) and then go out to raise the amount with debt instruments or from owners the funds needed to finance the resulting capital budget.
In real life, firms often opt for the first approach, because a given management team can handle only a certain number of new projects at any one time.
Two major methods usually used in capital budgeting are
(i) Discounted measures (take time value of money into consideration)
(ii) Undiscounted measures