http://valuationacademy.com An Introduction to Capital Budgeting — Valuation Academy

An Introduction to Capital Budgeting

Capital Budgeting, broadly defined as a decision-making process that enables managers to evaluate and recognize projects that are valuable to the company, is usually the dominant mission facing any financial manager and his/her team. It is the most important task for managers for the following reasons.

First, the strategic decisions and directions of a company, new products, new services, and expansion into new markets, are determined by the company’s capital budgeting. Second, capital budgeting decisions usually result in relatively long-lasting effects to the company, and therefore a decrease in flexibility. Third, serious consequences may arise from poor capital budgeting decisions. For example, if a company devoted too much capital to one project, the company’s capital would be unnecessarily spent on excess production capacity. On the other hand, if less-than-required capital was invested by the company, its productivity would suffer by the simple fact that its equipment, computer hardware and software might not be cutting-edge to improve production. These poor capital budgeting decisions may allow rival companies the opportunity to steal market share by taking advantage of a lower cost structure or production capabilities matching demand.

Most textbooks classify capital budgeting projects roughly into the following five categories.

(1)   Replacement projects: If a piece of equipment is out-dated or hinders efficient production, company’s usually tends to avoid overanalyzing whether to replace the older equipment. This type of project is usually carried out without detailed analysis.

(2)   Expansion projects: These projects expand the volume of the business product lines, and more uncertainties of sales forecasts should be considered. Very detailed analyses are usually involved in this instance.

(3)   New products and services: New products and services require more complex decision-making processes, and careful capital budgeting decisions are necessary.

(4)   Mandatory projects: These types of projects are required by the government, an insurance company, or some other agency. These projects are usually related to safety or the environment and are typically not revenue-generating. Capital budgeting decisions are typically made to reach the objective at the lowest cost to the company.

(5)   Other projects: Other capital budgeting projects not directly categorized under the previous four fall under “other projects.” This may be a pet project of the CEO, or Apple Computer allowing Steve Jobs to run the Macintosh team at a remote office. These types of projects are not subject to capital budgeting analysis.