Basic Principles of Capital Budgeting

Capital budgeting is the process of evaluating and implementing a firm’s investment opportunities, by virtue of properly identifying such investments that are likely to enhance a firm’s competitive advantage and increase shareholder wealth. A typical capital budgeting decision involves a large up-front investment followed by a series of smaller cash inflows. A typical capital budgeting process is focused around following basic principles:

Decisions are based on potential cash flows and not accounting income: If a project is undertaken and subsequently some relevant incremental cash flows are to flow out by virtue of such a capital budgeting plan, the relevant cash flows are to be considered as a part of the budgeting process, and the decisions on capital budgeting have to take such incremental cash flows into consideration, before properly evaluating such a capital budgeting plan. However, the sunk costs, which can’t be avoided, even by overlooking or avoiding such a capital budgeting plan, should not be considered for acceptance or rejection of the project.

However, while finalizing a capital budgeting decision, one needs to examine the impact of implementing such a plan on the cash flows of related activities undertaken by the same group, which has some synergy with the proposal for which the capital budgeting is being undertaken. If the sales of some related company within the same group are likely to face shrinkage following the implementation of such a plan, the capital budgeting plan should take such a potential cash inflow loss into account, before going for the proposed plan. In other words, if potential cash flows are likely to have a detrimental affect on the cash flows emerging out of existing business, both of them need to be examined carefully before finalizing the capital budgeting plan. Such a typical case, where an existing cash flow may suffer due to potential cash flow of the new/ improved facility is called cannibalization or externality.

For example, if a day-care center decides to open another branch within a distance of 10 km from existing one, the impact of customers who decide to move from one facility to the new facility that is now closer to their work place must be considered.

A project could have a conventional cash flow pattern, which typically means a cash flow at the time of undertaking such a capital budgeting plan, to be followed a series of cash inflows over the years to follow.

However, at times, there could be cases where the project may also have more than one cash outflows, like the one at the start, which could follow at the time of retirement of project. Such cases are called non conventional cash flow patterns.

Cash flows are based on opportunity costs: Any firm that undertakes an analysis of taking up a project may end up finding up that there may be alternate plans available to boost its potential cash flows out of the funds it is applying in the capital budgeting. Such cash flows which need to be foregone, for undertaking the capital budgeting plan, are typically considered as the opportunity costs for the firm and are key parameter before making a choice on whether to implement the project, or forego it. Such opportunity costs should be duly considered while making a final choice on whether or not to implement the new project.

Timing of Cash Flow: It should be kept in mind that the timing of cash flows subsequent to the capital budgeting (when the cash outflows move out of system), are important for undertaking a project. Typically, the earlier the cash inflows start to plough back into the business, the higher is its value.

Post tax analysis: It is important to note that all cash flows accruing into the business should be considered only after taking into account the tax implication of such cash inflows or only on a post tax basis.

Financing costs reflected in project’s required rate of return: Once the opportunity costs are considered to evaluate the project, it is widely accepted that the project no longer requires considering the financing costs, which get built into the system automatically, once the entire project is examined with a perspective from the required rate of return.