Capital budgeting is a method of evaluating large investment projects and determining if they should be undertaken. Capital budgeting features large capital investments usually with their determinable cash flows. These can be in the form of say processing plants or entire businesses that can standalone. The decision of whether or not to invest will depend on a comparison of the price expected to be paid for the investment compared to the sum of its cash flows. In finance, the value of an asset is the sum of it’s future discounted cash flows. Let’s look at the features of capital budgeting.
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The first feature of capital budgeting is that decisions generally involve very large outlays. The investments considered, as mentioned earlier, tend to be very large. Therefore the capital budgeting process is not a small matter at all. It also means that the impact of a failed attempt is not small just as the windfall in the event of success will be large as well. These decisions range in the millions of Dollars and upward to hundreds of millions.
A high degree of risk
As we have already alluded to these decisions tend to involve quite a high degree of risk. This second capital budgeting feature underscores the importance of the process to decision-makers. Capital budgeting decisions are usually linked to investments in new areas or capabilities. Because there is much that is unknown about the field or area they represent a risk. Consider a business that normally manufactures televisions that considers investing in a plant to manufacture their mobile phones. This is virgin territory for them so quite risky. They may have some strategic capability in the area that mitigates risk but that investment is still risky.
Affects Future Competitive Strengths
In the above-mentioned capital budgeting feature, we considered how these investments represent growth into new areas. In the majority of cases of such investment if not all of them the goal of an organisation is to gain new competitive strengths. Either in new fields or new technology that useful in their present field or future-focused. The acquisitions in mobile phone manufacturers are the easiest way to understand how this works. Samsung purchased a leading screen manufacturer while Apple purchased a company that specialised in fingerprint identification for mobile devices.
The decisions involved in capital budgeting are never easy. To understand this feature of capital budgeting we need to look back in history at Netflix and it’s now-defunct competitor Blockbuster. Blockbuster was a titan of home video rental while Netflix was an upstart that offered postal service home video rentals. Blockbuster on multiple occasions had the opportunity to buy the now billion-dollar company for amounts as low as US$1 million. At the time Blockbuster decided against this, in essence valuing Netflix at less than US$1million. Netflix’s view on video rental would make them ready for the time when internet speeds allowed users to stream video, Blockbuster with its store network slowly came to a grinding halt. In hindsight, it is easy to say Blockbuster chose wrong but the valuation of Netflix may have played a major part in the decision. This is a very important feature of capital budgeting.
Estimation of Large Profits
Calling back to our first capital budgeting feature, the size of the projects means they come with often commensurate profits or losses. The question of capital budgeting is a question of profitability. By making a large outlay now the business expects a certain level of inflows to come in as a result of the outlay made. This, of course, applies to both investments in assets or outright business purchases.
Long Term Effect
The next important feature of capital budgeting to look at is the enduring effect of those decisions. In most cases, the outlay is immediate while the benefits of the outlay may endure for many years to come. It is not unusual to have cashflows expected from some of these investment decisions expected for 25 or more years. This is where discounting comes in. As stated before the value of an asset is the present value of its future cash flows. $100 today is worth more than $100 one year from now because of effects such as inflation and opportunity cost; how much we could have made from that $100 if we invested it for a year. Discounting helps us take this into account when valuing cash flows.
Affects Cost Structure
Capital budgeting decisions will have an impact on the cost structure of a business. Let us take the of an investment in a new manufacturing plant. The cost of the land and construction of the plant are paid or financed upfront. However costs such as insurance, interest on finance, depreciation and other fixed charges will be added on going forward. All of this must be included in the scope of the capital budgeting decisions. It may not seem like a large outlay compared to the initial outlay however this is an essential feature of capital budgeting because it must consider the net flows of a project and not just inflows.
The size and nature of these decisions make them difficult, if not impossible to reverse. Take our manufacturing plant example from the previous capital budgeting feature. If the project fails within say a year, it is highly unlikely that we will find someone who wants to purchase a plant with similar specifications. It is more than likely that it would have to be sold off at scrap value or certainly at a deep discount. For this reason, capital budgeting decisions need to consider the outcomes very carefully.
As we can see capital budgeting has many features at play at any given time. The nature of decisions made is not always straight forward choices. Capital budgeting decisions also include mutually exclusive projects, a cut off rate of return and capital rationing decisions. Each of the capital budgeting features explained above play a role in shaping the practice and principles of capital budgeting.