What is Capital Budgeting?
Capital budgeting is a set of techniques used to decide when to invest in projects. For example, one would use capital budgeting techniques to analyze a proposed investment in a new warehouse, production line, or computer system. There are a number of capital budgeting techniques available, which include the following alternatives.
Discounted Cash Flows Analysis
Under the discounted cash flows method, estimate the amount of all cash inflows and outflows associated with a project through its estimated useful life, and then apply a discount rate to these cash flows to determine their present value. If the present value is positive, accept the funding proposal. The weakness of this approach is that future cash flow projections are being used, and so could be quite inaccurate.
Advantages of Discounted Cash Flows Analysis
The main advantage of discounted cash flows analysis is that it takes account of the time value of money, which is a massive consideration when cash flows are expected to cover many periods, and especially when the discount rate is high. In addition, it mandates that all cash inflows and outflows be included in the analysis, which is a comprehensive approach to capital budgeting analysis. And finally, because of its sole focus on cash flows, it is an easy way to run comparisons on the cash flows of multiple proposed projects, to determine which one is best.
Disadvantages of Discounted Cash Flows Analysis
The main concern with discounted cash flows analysis is that it calls for estimates of future cash flows, which can be extremely difficult to derive. Also, these future cash flows can be fudged to make a proposed project look better than it really is. Another concern is that the applicable discount rate must be applied to the analysis, and this rate can be difficult to derive. A further concern is that it can be a complicated task to derive this analysis, especially for a larger and more complex project. Finally, this analysis is solely concerned with cash flows, and so does not take into account any qualitative factors, such as the impact of a proposed project on the environment.
Internal Rate of Return
Under the internal rate of return method, determine the discount rate at which the cash flows from a project net to zero. The project with the highest internal rate of return (IRR) is selected. The weakness of this approach is that the projects selected are not necessarily linked to the strategic direction of the business.
Constraint Analysis
Under the constraint analysis method, examine the impact of a proposed project on the bottleneck operation of the business. If the proposal either increases the capacity of the bottleneck or routes work around the bottleneck, thereby increasing throughput, then accept the funding proposal. This is perhaps the strongest capital budgeting method, since it focuses attention on just those areas that directly impact overall company profitability.
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Breakeven Analysis
Under the breakeven analysis method, determine the required sales level at which a proposal will result in positive cash flow. If the sales level is low enough to be reasonably attainable, then accept the funding proposal. This approach sets a minimum threshold for the projects to be selected.
Discounted Payback
Under the discounted payback method, determine the amount of time it will take for the discounted cash flows from a proposal to earn back the initial investment. If the period is sufficiently short, then accept the proposal. This approach emphasizes a fast payback, and so is more appropriate when long-term returns are uncertain.
Accounting Rate of Return
Under the accounting rate of return method, one would calculate the ratio of an investment’s average annual profits to the amount invested in it. If the outcome exceeds a threshold value, then an investment is approved. This approach should not be used, since it does not account for the time value of money.
Real Options
Under the real options method, one would focus on the range of profits and losses that may be encountered over the course of the investment period. The analysis begins with a review of the risks to which a project will be subjected, and then models for each of these risks or combinations of risks. The result may be greater care in placing large bets on a single likelihood of probability.
Complexity Considerations
When analyzing a possible investment, it is useful to also analyze the system into which the investment will be inserted. If the system is unusually complex, it is likely to take longer for the new asset to function as expected within the system. The reason for the delay is that there may be unintended consequences that ripple through the system, requiring adjustments in multiple areas that must be addressed before any gains from the initial investment can be achieved.
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