Overview of capital budgeting

Capital expenditure of the enterprise refers to the investments which are expected to bring benefits (cash inflows) over period of time longer than one year. An example of capital expenditure is investment in building a new factory. This is in comparison to current (operating) expenditure, which refers to short-term investment with expected benefit over period of less than one year.

Capital budgeting is very important area of financial management and imperative managerial tool. It refers to analyzing and selecting capital expenditure (long-term investments) with the goal of maximizing shareholder’s wealth. In other words, capital budgeting helps to justify those certain capital expenditures that should be undertaken by the enterprise.

Capital budgeting is especially crucial area of financial management because it deals with long-term decisions, which will determine future performance of the organization.

The motivations for capital expenditures include expansion, replacement, modernization and other. Each motivation have its own factors to be considered when determining its validity for capital expenditure. For example, in case of replacement, an optimal replacement frequency should be taken into account which considers minimizing costs of replacement in conjunction with maximizing salvage value of old assets.

There are many formal techniques, which are used in capital budgeting.  Such methods include sophisticated capital budgeting techniques such as net present value (NPV), internal rate of return (IRR), Equivalent annual annuity (EAA) and Profitability index (PI) as well as unsophisticated capital budgeting techniques such as payback period (PB, also called payback method) and average rate of return (ARR).

Type of projects

When choosing a capital expenditure (a long-term investment project), it is important to consider whether project is independent or mutually exclusive. Independent projects are projects that are independent of one another and any number of acceptable independent projects may be selected. In other words, acceptance of one independent project does not disqualify acceptance of another independent project. Mutually exclusive projects compete with one another and only one can be selected. In other words, if projects A and B are mutually exclusive than acceptance of project A implies that project B have to be abandoned.

Projects can also be complementary in which case synergy causes undertaking of one independent project (eg project A) to bring increase in cash flows for another independent project (eg project B). In other words, based on the previous example, projects A and B are complementary because an increase in cash inflow of project B would not occur if project A were not undertaken.

Cash flow patterns

Cash flows can also have conventional or non-conventional cash flow patterns. Conventional cash flow pattern refers to situation where initial outflow followed only by inflows. In other words, there is only one change in the cash flow sign. For example, “-, +, +, +”, where minus sign refers to cash outflow and plus sign refers to cash inflow.

Non-conventional cash flow pattern refers to situation where initial outflow followed by both inflows and outflows. In other words, in non-conventional cash flow pattern there is more than one change in the cash flow sign. For example, “-, +, -, +, -“, where minus sign refers to cash outflow and plus sign refers to cash inflow. The non-conventional cash flow pattern is more difficult to analyze. Below we will only consider projects with conventional cash flow pattern.

Conclusion

As per above, capital budgeting is very important area of financial management and imperative managerial tool. To start capital budgeting decision-making process, we firstly need to look at the cash flows of the proposed projects.

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