Principles of Capital Budgeting

Even though the capital budgeting decisions can be very complex with lots of underlying assumptions and variations, most decisions have the following basic principles underlying them.

1. Decisions are based on cash flow not accounting income

The capital budgeting decisions are based on the cash flow forecasts instead of relying on the accounting income. These are the incremental cash flows, that is, the additional cash flow that will occur if the project is undertaken compared to if the project is not undertaken.

While estimating these cash flows certain costs such as the sunk cost will be ignored. This is because sunk cost is the cost that is already incurred whether the project is undertaken or not. Similarly any intangible costs and benefits are ignored.

The investment analysis should also account for any externalities. An externality refers to the effect of the project/investment on other things than the project itself. A common externality is cannibalization, where a new project reduces the cash flow of another project. This is a negative externality. A project can also have a positive externality where a new project has positive effect on the revenue from another project.

2. Timing of cash flow

Another important aspect of the analysis is to estimate the timing of cash flow as accurately as possible. As the capital budgeting analysis uses the concept of time value of money, the time at which the cash flow occurs significantly impacts the present value of the project. The earlier the cash flow occurs the more valuable it is.

3. Opportunity cost should be considered

The project analysis should include opportunity costs. Opportunity cost is the cash flow that the company loses because of undertaking the new project.

4. Cash flow should be adjusted for taxes

After-tax cash flow should be used for capital budgeting analysis.

5. Financing Costs Should be Ignored

Financing costs should not be included in the cash flow. Analysts will take the after-tax operating cash flows and will discount them using the required rate of return to arrive at the net present value. The financing costs are already reflected in the required rate of return and the cash flow should not be adjusted for the same, irrespective of whether the project is financed using equity, debt or a combination of both.

A project may have conventional or unconventional cash flow pattern. In case of a conventional cash flow pattern, there is an initial outflow of cash followed by one or more cash inflows. In case of unconventional cash flows, there could be a series of cash inflows and outflows at different times.

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