Principles of Capital Budgeting

Capital Budgeting is relatively known as an investment appraisal, a significant process in

planning that is used in order to determine if the investment made by an organization is worth
pursuing.

These investments may include replacement machinery, new products, new plants, new
machinery, and development projects. Capital budgeting simply includes a budget for
expenditure, major capital and investment. 

Additionally, there are formal methods basically used in capital budgeting that include many
techniques. These techniques include the “net present value”, payback period, “accounting
rate of return”, profitability index, equivalent annuity and “internal rate of return”.

All these methods make use of cash flows from a potential project or investment. Techniques
primarily based on accounting rules and accounting earnings are used. However, economists
consider some of these techniques as improper. Hybrid and simplified methods are
sometimes used such as “discounted payback period” or “payback period”.

Capital budgeting merely attempts to determine the future. Its process should first be utilized
before starting a large project. Without an efficient capital budgeting, your own company
may make its fatal mistake. Here are some of the aspects of capital budgeting, as each one
has to play its critical role to your success.

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.

Principles of Capital Budgeting

Capital budgeting has five principles that play a crucial role in the allocation of money and
the process of capital budgeting.  The five principles are; (1) decisions are based on cash
flows, not accounting income, (2) cash flows are based on opportunity cost, (3) The timing of
cash flows are important, (4) cash flows are analyzed on an after tax basis, (5) financing costs
are reflected on project’s required rate of return.

(1)    Relevant cash flows are based on incremental cash flows. This represents the changes in
cash flow if the project is undertaken. Aspects of cash flow that affect capital budgeting are
sunk costs and externalities. These are both costs that cannot be avoided. Sunk costs are costs
that are unavoidable, even if the project is undertaken. Externalities are side effects of a
project that affect other firm cash flows.
(2)    Cash flows are based on opportunity cost. In other words, it is the cash flow that will be
lost due to the financing of a project. These are cash flows that are accumulated by assets the
firm already owns and would be sunk if the project under consideration is undertaken.

(3)    The timing of cash flow is crucial because it is dependent on the time value of money.
Cash flow that is received now will be worth more in the future if it were to be received later.

(4)    Cash flows are measured on an after tax basis. It is useless to measure cash flow before
taxes because it is not its present value. Firm’s value is based on cash flow that a firm gets to
keep, not the money that is sent to the government.

(5)    Financing costs are reflected on project’s required rate of return. Rate of return is an
aspect of financing that has potential risks. Project’s that are expected to have a higher rate of
return than their cost of capital will increase the value of the firm.