“The habit of saving is itself an education; it fosters every virtue, teaches self-denial, cultivates the sense of order, trains to forethought, and so broadens the mind.”
– T.T. Munger
The Capital Budgeting Decision
by
Charles Lamson
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The decision on capital outlays is among the most significant a firm has to make. A decision to build a new plant or expand into a foreign market may influence the performance of the firm over the next decade. The capital budgeting decision involves the planning of expenditures for a project with a life of at least one year, and usually considerably longer. In the public utilities sector, the time horizon of 25 years is not unusual. The capital expenditure decision requires extensive planning to ensure that engineering and marketing information is available, product design is complemented, necessary patterns are acquired, and the capital markets are tapped for the necessary funds. Throughout the next few posts we will use techniques developed under the discussion of the time value of money to equate future cash flows to the present, while using the cost of capital as the basic discount rate. It should be pointed out that capital budgeting is not only important to people in finance or accounting, it is essential to people throughout the business organization. For example, a marketing or production manager who is proposing a new product must be familiar with the capital budgeting procedures of the firm. If he or she is not familiar with the concepts presented in these next several posts, the best idea in the world may not be approved because it has not been properly evaluated and presented. You must not only be familiar with your product, but also with its financial viability.  In the next few posts capital budgeting is studied under the following major topical headings: administrative considerations, accounting flows versus cash flows, methods of ranking investment proposals, selection strategy, capital rationing, combining cash flow analysis and selection strategy, and the replacement decision. Later in the chapter, taxes and their impact on depreciation and capital budgeting decisions are emphasized. Administrative Considerations A good capital budgeting program requires that a number of steps be taken in the decision-making process.
The search for new opportunities is often the least emphasized, though perhaps the most important, of the four steps. The collection of data should go beyond engineering data and market surveys and should attempt to capture the relative likelihood of the occurrence of various events. The probabilities of increases or slumps in product demand may be evaluated from statistical analysis, while other outcomes may be estimated subjectively. After all data have been collected and evaluated, the final decision must be made. Generally determinations involving relatively small amounts of money will be made at the department or division level, while major expenditures can be approved only by top management. A constant monitoring of the results of a given decision may indicate that a new set of probabilities must be developed, based on first year experience, and the initial decision to choose Product A over product B must be reevaluated and perhaps reversed. The preceding factors are Illustrated in Figure 1 below.   Accounting Flows versus Cash Flows In most capital budgeting decisions the emphasis is on cash flow rather than reported income. Let us consider the logic of using cash flow in the capital budgeting process. Because depreciation does not represent an actual expenditure of funds in arriving at profit, it is added back to profit to determine the amount of cash flow generated. Assume the Lamson Corporation has $50,000 of new equipment to be depreciated at $5,000 per year. The firm has $20,000 in earnings before depreciation and taxes and pays 35 percent in taxes. The information is presented in Table 1 to illustrate the key points involved. Table 1 Cash flow for Lamson Corporation  The firm shows $9,750 in earnings after taxes, but it adds back the noncash deduction of $5,000 in depreciation to arrive at a cash flow figure of $14,750. The logic of adding back depreciation becomes even greater if we consider the impact of $20,000 in depreciation for the Lamson Corporation (Table 2). Net earnings before and after taxes are zero, but the company has $20,000 cash in the bank. Table 2 Revised cash flow for Lamson Corporation  To the capital budgeting specialist, the use of cash flow figures is well accepted. However, top management does not always take a similar viewpoint. Assume you are the president of a firm listed on the New York Stock Exchange and must select between two alternatives. Proposal A will provide zero in aftertax earnings and $100,000 in cash flow, while Proposal B, calling for no depreciation, will provide $50,000 in aftertax earnings and cash flow. As president of a publicly traded firm, you have security analysts constantly penciling in their projections of your earnings for the next quarter, and you fear your stock may drop dramatically if earnings are too low by even a small amount. Although Proposal A is superior, you may be more sensitive to aftertax earnings than to cash flow and you may therefore select Proposal B. Perhaps you are overly concerned about the short-term impact of a decision rather than the long-term economic benefits that might accrue.  The financial manager must be sensitive to executives' concessions to short-term pressures. Nevertheless in the material that follows, the emphasis is on the use of proper evaluation techniques to make the best economic choices and assure long-term wealth maximization. *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, PP. end |
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