Capital Budgeting

Abstract

Capital budgeting is the procedure for establishing whether or not a company should invest in projects such as new facilities or products. This article presents the most common methods of capital budgeting; discusses economic issues in capital budgeting unique to three types of companies: Steel producers, small companies, and U.S. multinational subsidiaries; and provides a glossary of relevant terms.

Keywords Capital Budgeting; Cash Flow; Discounted Cash Flow (DCF); Internal Rate of Return (IRR); Manufacture; Net Present Value (NPV); Payback Period; Present Value (PV)

Manufacturing > Capital Budgeting

Overview

When a company plans to invest in new facilities, equipment, or products, it may engage in capital budgeting. Capital budgeting is a strategy that a company can utilize to plan future investment projects.

A company utilizes capital budgeting to establish whether a project’s benefits will outweigh the costs of investing in the project. The process generally involves constructing a formula that considers total funds needed for the project, including working capital; the financial benefits expected from the project; the length of time needed to reap the financial benefits of the project; and whether it is better to forego the project completely. For example, a company that manufactures furniture is considering whether or not to also start manufacturing its own fabric for the furniture. The furniture manufacturer can use capital budgeting to determine the most financially profitable option for manufacturing fabric among the following four investment projects:

• Remodel a current facility to accommodate a fabric manufacturing operation.
• Build a new fabric manufacturing facility.
• Purchase an existing fabric manufacturing company.
• Continue to purchase the fabric rather than manufacture it. (If this option is chosen, the project is then removed from consideration as a capital budgeting project.)

Further Insights

As part of the capital budgeting process, companies consider their access to funds; their need for cash flow to operate the company throughout the time line for any capital budgeting project; and in some instances, their responsibility to shareholders.

Capital Budgeting Valuation Methods

A variety of approaches and mathematical formulas may be used in capital budgeting. Four of the most common approaches used in capital budgeting are based on the following four valuation methods:

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Discounted Cash Flow (DCF)
• Payback Period

Net Present Value (NPV)

The first capital budgeting valuation method is net present value (NPV). NPV reflects the variance between the current amount of cash inflows and the current amount of cash outflows. "Present value" refers to the current worth of money that will be received in the future, based on a particular rate of return.

Internal Rate of Return (IRR)

The second capital budgeting valuation method is internal rate of return (IRR). IRR, which is sometimes called "economic rate of return," refers to the discount rate that renders the NPV of all cash flows for a specific project equal to zero. Usually, the higher the IRR for a specific project, the more financially attractive the project will be.

Discounted Cash Flow (DCF)

The third capital budgeting valuation method is discounted cash flow (DCF). In DCF, future free cash flows are discounted to arrive at a present value. For a project to be considered worthwhile according to this valuation method, the DCF must be greater than the present investment cost.

Payback Period

The last capital budgeting valuation method is payback period. The payback period refers to the amount of time needed to recapture the cost of an investment. In general, the sooner a company can recover the cost of their investment, the more financially attractive the project will be.

The payback method of valuation does not measure the time value of money or reflect any financial benefits that would occur after the payback period. Therefore, this method of capital budgeting is considered less effective than the NPV, IRR, or DCF methods.

Issues

Economic Issues in Capital Budgeting Decisions

In addition to considering their corporate financial goals, companies need to also consider how national and international economic issues will affect their capital budgeting decisions.

This section explores three topics that consider the economic issues that affect capital budgeting:

• A capital budgeting issue for U.S. steel producers.
• The capital budgeting decisions of small companies.
• The results of an analysis of capital budgeting strategies of U.S. multinational subsidiaries.

A Capital Budgeting Issue for U.S. Steel Producers

The first economic issue in capital budgeting covers a capital budgeting issue for U.S. steel producers.

Should U.S. steel producers expand their capacity in order to avoid being the lowest-cost suppliers to the U.S. market? At least one industry analyst says "No." Michelle Applebaum, an independent steel industry analyst, discusses why she disagrees with those who think that U.S. steel producers need to expand their capacity (production) in order to prosper in the marketplace.

Applebaum offers three reasons why expanding capacity is not desirable:

• Limited resources, such as scrap metal, are available.
• The delivery of steelmaking equipment requires an exceptionally long lead time.
• The potential for a surge in exports from China remains an economic threat.

She reasons that any capital budgeting that includes a new capacity project would have to assume a period of negative returns in order to yield a net positive return (Applebaum, 2007, p. 91).

Instead of investing in capital budgeting projects to increase production capacity, Applebaum suggest that it would be more mutually beneficial for steel producers and their customers to engage in the following practices:

• Steel producers: Allow for flexible arrangements with customers. Reduce volume when business conditions warrant this practice, rather than forcing customers to buy according to previous contract arrangements.
• Customers: Honor your price commitments with the producers.
• Steel Producers and Customers: Share surcharge responsibility. Surcharges allow visibility into pricing for raw materials and as such are necessary, but producers can show flexibility; when the prices of raw materials decrease they can decrease the surcharges.

The Capital Budgeting Decisions of Small Companies

The second economic issue in capital budgeting covers the capital budgeting decisions of small companies.

Based on data compiled by the National Federation of Independent Business, Danielson and Scott (2006) analyzed the capital budgeting decisions of small businesses. Although the U.S. Small Business Administration defines small businesses as those with less than 500 employees, Danielson and Scott based their study on companies with fewer than 250 employees.

Danielson and Scott based their study on 792 observations and segmented the industries into four groups: service; construction and manufacturing; retail/wholesale; and other. Their analysis of the data addressed three aspects of capital budgeting in small companies:

• Investment Activity
• Planning Activity
• Project Evaluation Technique

Investment Activity

The first aspect of capital budgeting in small companies that is addressed is investment activity. For companies in the construction and manufacturing industries, their most significant investments during the previous year were almost evenly distributed among replacement of equipment, expansion of existing products, and introduction of a new product line.

Planning Activity

The second aspect of capital budgeting in small companies that is addressed is planning activity. For companies in the construction and manufacturing industries, 68% made cash flow projections before making a major investment; 32% wrote a business plan; and 71% considered their tax situation.

Project Evaluation Technique

The last aspect of capital budgeting in small companies that is addressed is project evaluation technique. The majority of construction and manufacturing companies (22%) used an informal "gut feel" method to determine whether a project was financially attractive. At 19%, the payback period method was the second most popular evaluation technique in capital budgeting among this group of companies.

Analysis Conclusions

In summary, Danielson and Scott (2006) concluded that the capital budgeting strategies of small companies are often characterized by the following factors:

• They frequently balanced wealth maximization against objectives such as maintaining the independence of the business.
• They often lacked the personnel and resources to complete in-depth capital budgeting analyses.
• They frequently relied upon either the payback period method of capital budgeting or the owner's "gut feeling." This practice contrasts with that of large companies, who were more likely to use the discounted cash flow analysis method.

The Results of an Analysis of Budgeting Strategies of U.S. Multinational Subsidiaries

The last economic issue in capital budgeting covers the budgeting strategies of U.S. multinational subsidiaries.

According to a study by Hasan, Shao, & Shao (1997) of 159 foreign subsidiaries of U.S.-based multinational manufacturing enterprises operating in 43 companies, additional influences complicate the capital budgeting decisions of multinational subsidiaries. They identified the following five complicating factors (Hasan, Shao, & Shao, 1997, p. 68):

• Complex Cash Flow Estimates;
• Foreign Exchange Rate Fluctuations;
• Varying Accounting Systems;
• Financial Risks;
• Political Uncertainties.

The authors determined that the capital budgeting process for multinational enterprises is affected by factors that do not affect domestic companies.

Based on their analysis of the survey respondents' responses, they reached the following conclusions (Hasan et al., 1997, p. 75):

• The refinement of the capital budgeting strategies of foreign subsidiaries correlated to levels of ownership status and financial leverage. In general, in those situations where the parent companies owned most of the subsidiaries’ shares, more sophisticated capital budgeting strategies were likely to be employed.
• The sources used to determine discount rates were positively related to the age of the firm, total asset size, and whether the subsidiaries were publicly traded.
• Publicly traded subsidiaries, firms with credit regulations implemented by outside creditors, and asset size were closely associated with refined risk-adjustment capital budgeting strategies.

Conclusion

When a company engages in capital budgeting, it carefully assesses which projects are most important to the company's strategy and financial future because capital budgeting projects will consume a large financial investment and greatly affect operating cash flow. Capital budgeting projects therefore must take into account whether the future benefits of the projects will outweigh the financial investment and whether the company can afford to financially support the project and also continue operating the company for the duration of the capital projects.

Various methods and mathematical formulas are available for capital budgeting. Most large companies will choose one of the three most popular capital budgeting methods: net present value (NPV), internal rate of return (IRR), or discounted cash flow (DCF). Small companies with fewer than 250 employees, choose the "gut feeling" approach to capital budgeting most frequently, followed by the payback period method. The payback period method is more attractive to smaller companies because it relies upon the shortest possible time to recapture the cost of the investment in the project. However, the payback period method does not measure profitability because it does not take into account any benefits that accrue after the payback period and it also does not account for the time value of money. For these reasons, the payback method of capital budgeting is not used as frequently by larger companies, who are usually in a better position to wait longer to recoup their investments. The capital budgeting strategies for the foreign subsidiaries of U.S multinational companies are complicated by five unique factors: complex cash flow estimates; foreign exchange rate fluctuations; varying accounting systems; financial risks; and political uncertainties.

Terms & Concepts

Capital Budgeting: The strategy used by businesses to plan out the viability of future investments.

Cash Flow: The cash flow statement demonstrates the amount of cash produced and spent by a company during a certain time period, measured by adding non-cash charges (including depreciation) to net income post-taxes. Cash flow can be associated with a certain project or to a whole company. Cash flow can be used to represent a company’s financial viability.

Cash Inflows: Mainly generated from one of three activities: financing, operations, or investing. Cash inflows can also occur through donations or gifts.

Cash Outflows: Result from expenses or investments.

Discounted Cash Flow (DCF): A valuation strategy utilized to determine the benefits of an investment opportunity. DCF analysis looks at future free cash flow predictions and discounts them (usually using the weighted average capital cost) to reach a present value, which is then used to assess the investment possibility. If the value derived from DCF is greater than the present investment cost, the opportunity might be an attractive one.

Free Cash Flow: A measurement of financial strength measured by subtracting capital expenditures from operating cash flow. Free cash flow demonstrates the cash that a company can produce without including the funds necessary to upkeep or add to its base assets.

Internal Rate of Return (IRR), also known as Economic Rate of Return (ERR): The discount rate employed during capital budgeting analysis that equates the net current value of all cash flows from a given project to zero. Usually a higher internal rate of return means that a project is a more attractive proposition. Companies can use this rating to evaluate a number of potential projects. With all other factors staying consistent between projects, the project with the highest IRR would most likely be chosen.

Manufacture: To make a product from raw materials by hand or by machine.

Net Present Value (NPV): The variation between the current amount of cash inflow and the current amount of cash outflow. NPV is used during capital budgeting to assess the profitability of a potential investment or future project.

Payback Period: The amount of time necessary to recapture an investment cost. If all other factors are consistent, the best investment is the one with the shortest payback period.

Present Value (PV), or Discounted Value: The present value of a future sum of money or cash flows given a certain return rate. Future cash flows are discounted at the discount rate. The higher the discount rate is, then the lower the current value of the future cash flows will be. Identifying the accurate discount rate is critical to effectively determining the value of future cash flows, regardless of whether they are earnings or obligations. The basic premise is that receiving $1,000 at the present is more valuable than receiving the same $1,000 in five years because during the intervening five years you could have invested it and received addition returns.

Small Businesses: Danielson & Scott (2006) cite the U.S. Small Business Administration definition of small businesses as "firms with fewer than 500 employees." However, the U.S. Small Business Administration actually limits the size based on industry according to the North American Industry Classification System (NAICS).

Bibliography

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Suggested Reading

Bimal, N., et al. (2007). A quality-based business model for determining non-product investment: A case study from a Ford automotive engine plant. Engineering Management Journal, 19, 41–56. Retrieved November 26, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27350377&site=ehost-live

Dedi, L., & Orsag, S. (2007). Capital budgeting practices: A survey of Croatian firms. South East European Journal of Economics & Business, 2, 59-67. Retrieved November 26, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25657478&site=ehost-live

Hyde, J., Dunn, J. W., Steward, A., & Hollabaugh, E. R. (2007). Robots don't get sick or get paid overtime, but are they a profitable option for milking cows? Review of Agricultural Economics, 29, 366–380. Retrieved November 26, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24594303&site=ehost-live

Soloman, M. J. (2015). Investment decisions in small business. Lexington: University Press of Kentucky. Retrieved December 3, 2015, from EBSCO online database eBook Collection (EBSCOhost). http://search.ebscohost.com/login.aspx?direct=true&db=nlebk&AN=938835&site=ehost-live