Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm's goal of maximizing owner wealth. A firm using capital budgeting, their goal is to see if there fixed income will cover itself for profit. Fixed incomes are things such as land, plant and equipment. When a firm using a machine to produce its good or service. They most of the time what the machine to
produce the amount that they paid for the machine and more. The capital expenditure is the outlay of fund that a firm expects to produce and benefit with in a one year.
The Capital Budgeting Process
When approaching the problem of trying to the measure capital budgeting. The first step in capital budgeting is the Proposal generation. The proposals are made at all levels within a business organization and are reviewed by finance personal. The Second step in the process in the review and analysis. The formal review and analysis is performed to assess the appropriateness of proposals and evaluate their economic viability. Once the analysis is complete, a summary report is summated to decision makers. The third step in the process will be the Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar limits. The board of directors must authorize expenditures beyond a certain amount. Often plant manager are given authority to make decisions necessary to keep the production line is moving.
The forth step in the capital budgeting process is the Implementation. This process involves expenditures that come from projects implemented. Expenditures for a large project often in these phases. The final step in the process will be the follow-up stage. Results are monitored and tell the actual outcomes.
Sunk cost and Opportunity Cost
Doing the time of estimating the relevant cash flows associated with a proposed capital expenditure, the firm must recognize any sunk cost and opportunity cost. When determining projects incremental cash flows. The suck costs are cash outlays that have already been made and have no effect on the cash flows.
The opportunity costs are cash flows that could be realized from the best alternative use of an owned asset.
Net present Value (NPV)
The NPV gives explicit consideration to the time value of money. The NPV is considered a sophisticated capital budgeting technique. The NPV is measured by subtracting a project's initial investment from the present value of the cash inflows discounted at a rate equal to the form cost of capital. The NPV measures inflows and out flows. When putting your input in to the chart. The chart requires the amount of years that the firms think it will take to retrieve its investment. The input of the out flow is entering in to the charts as a negative. The reason why the number is entered as a negative is because that is the amount of money the firm is giving out to pay for the machine.
LIFE OF PROJECT
DISCOUNT RATE/ REQUIRED
RATE OF RETURN (i) 8.000%
CASHFLOWS ($$) (58,300.00) 19,080.00 15,900.00 26,500.00 10,600.00 8,480.00
YEAR 0.00 1.00 2.00 3.00 4.00 5.00
Recaptured depreciation is the portion of an asset's sale price that is above its book value and below its initial purchase price. When a firm uses this method they are simple taking an old machine and selling it for more then the current worth. We will now look at an example of "recaptured depreciation". A few years ago, Ransack Industries implemented an inventory auditing system at an installed cost of $159,000, has taken depreciation totaling $112,890. If Ransack sold the system for $$99,852, how much recaptured depreciation would result? Recaptured depreciation=Sale price-Book value, Book value=Installed cost of the asset-Accumulated depreciation,
Installed Cost = 159,000
Depreciation = 112,890
Selling Price = 99,852
Book Value = 46,110
Recaptured Dep. = 53,742
Global Capital Budgeting
In the international business world firms also use the Capital budgeting process. When entering in to the international market there a couple of thing that are measured different. The First thing is the cash outflows and inflows that occur in foreign currently Companies face long-term and short-term currency risk related to both the invested capital and the cash flows resulting form it. The Second thing is the foreign investment entail potentially significant political risk. Political risks can be minimized by using both operating and financial strategies.
When discussing capital budgeting, one must include the effects of technology. Technology assessment can support the capital budgeting process by providing key information for making decisions about capital requests. Technology assessment has been defined as a method for evaluating the effectiveness of equipment, drugs, and clinical procedures.(e) However, in terms of capital equipment planning, technology assessment can be defined more broadly as a method of evaluating current and requested capital equipment by considering the results of published clinical investigations and of physical assessment of the equipment in the decision-making process. Technology assessment provides information for decision making in three areas. The department's equipment needs. Information about a department's needs might include the role or purpose of the department, the type of procedures performed, the volume of activity, hours of operation, productivity problems, and so forth. This information contributes to an understanding of a department's operation and the issues it faces. The abilities of current equipment. An assessment of a department's current equipment involves collecting data about the equipments' condition, operation, repair record, current age, and so forth. The abilities of new or replacement equipment. Similar data also are gathered for new, emerging technologies or on new models that will replace existing equipment. An integrated process of capital budgeting and technology assessment can help capital budgeting committees allocate scarce capital resources to acquire equipment that best matches the needs of the hospital. The capital budgeting process provides a framework for decision making, and within this framework, technology assessment works both as a process and as an input to the capital budgeting process. Technology assessment thus becomes an extension of the capital budgeting process.
BUSINESS vs PRIVATE
Despite certain similarities, the differences between the way capital budgeting is done in the private sector and governmental budgeting are often great and in several respects decisive. In the first place, most private entities employ multiple budgets: capital budgets, operating budgets, and cash budgets. Private-sector capital budgeting is concerned only with decisions that have significant future consequences. Its time horizon is the life of the decision; its focus is the discounted net present value of the decision alternative. It is always distinguished from operating budgeting, which is concerned with motivating managers to serve the organization to the best of their abilities. In the operating budget the relevant time horizon is the operational cycle of the administrative unit in question, perhaps a month or even a week in the case of cost and revenue centers, usually longer where investment and profit centers are concerned. Operating budgets focus on the performance of the administrative unit, outputs produced and resources consumed -- where possible these are all measured in current dollars. Cash budgeting is concerned with providing liquidity when needed at a minimum cost. Most governments try to make one process do the work of three. Not surprisingly, that process usually fails to do any one thing very well. What governments do best is liquidity management, although, paradoxically, liquidity is rarely a serious concern to most national governments. Second, private-sector capital budgeting is selective. It is usually concerned only with new initiatives, and then only with changes in operations that are expected to yield benefits for longer than a year. Despite powerful inclinations to incrementalism, governmental budgeting tries to be comprehensive. All planned asset acquisitions, including current assets as well as long-term assets, are typically included under the appropriations/authorization process.
Third, private-sector capital budgeting tends to be a continuous process. Most well managed firms always have a variety of initiatives under development. The decision to go ahead with an initiative is usually made only once, when the initiative is ripe, and is usually reconsidered only if it turns sour. In contrast, budgeting in the government tends to be repetitive -- most appropriations are reconsidered annually on the basis of a rigid schedule.
Fourth, an initiative's sponsor or champion within the organization is usually given the authority and the responsibility for implementing it. In government the new initiative's champion is seldom assigned responsibility for its implementation; instead, that
responsibility is usually given to someone else, sometimes even in an entirely different department (see Bower, 1970).
Another difference is that the objective of capital budgeting in the private sector is the identification of options with positive net-present values, since in the absence of real limits on the availability of cash or managerial attention, the welfare of a firm's shareholders will be maximized by the implementation of all projects offering positive net-present values. While many government decisions are informed by cost-benefit and cost-effectiveness analysis (in the United States, federal water and power and state-construction projects have long been required to pass a benefit-cost test; Congress has recently imposed similar requirements on mandates and regulations; and federal loan-guarantee and insurance programs are funded in present-value terms), appropriations requests rarely show all the future implications of current decisions in present value terms. For example, in the United States, the federal government routinely reduces current outlays by delaying major acquisitions and maintenance efforts, often thereby increasing discounted costs sixty percent or more. This irrational policy is justified by the need to reduce the deficit and, thereby, avoid borrowing at interest rates of seven percent or less at present.
The biggest difference, however, between budget authority in most governments and the capital budgets approved by top management in the private sector lies in their relationship to operating budgets.
The Internal Rate of Return is a measure used to summarize the merits of an investment. It is very useful in ranking multiple projects when your budget only allows you to purchase a limited number of investments. By definition, the Internal Rate of Return is the discount rate that makes the Net Present Value equal to zero. An example of IRR is presented in the following text.
Tim now knows from the previous examples that the Net Present Value of his investment at year 5 is equal to $4,800. Tim would really like to at least break even on this investment by year 5. In order for this to be feasible the internal discount rate will have to be higher than the previous discount rate of 5%. This rate can be found by finding the internal discount rate where Net Present Value is equal to zero. At what internal discount rate would Tim's NPV be zero?
Normally the Internal Rate of Return is simply found by trial and error. However, on an excel spreadsheet you can easily enter in the data and let the computer come up with the answer to the following equation:
DETERMINING THE NET PRESENT VALUE DETERMINING THE IRR
Firm's cost of capital 5% Year-End Cash Flow
Year-End Cash Flow Year Project A
Year Project A 0 $ (20,000)
0 $ (20,000) 1 $ 4,800
1 $ 4,800 2 $ 4,800
2 $ 4,800 3 $ 4,800
3 $ 4,800 4 $ 4,800
4 $ 4,800 5 $ 4,800
5 $ 4,800 6 $ 4,800
6 $ 4,800 7 $ -
7 $ - 8 $ -
8 $ - 9 $ -
9 $ - 10 $ -
10 $ - IRR 11.53%
NPV = 0 = -(Cost) + (Cash Flow/ (1+r)t) + (Cash Flow/ (1+r)(t+1)) ... (CF/ (1+r)(T+n))
where r = the internal rate of return (IRR) & t = the period. Then solve for r to find the IRR. This is how excel found the Internal rate of Return to be 11.53 %.
In business as in personal finance, cash flows are essential to solvency. They can be presented as a record of something that has happened in the past, such as the sale of a particular product, or forecasted into the future, representing what a business or a person expects to take in and to spend. Cash flow is crucial to an entity's survival. Having ample cash on hand will ensure that creditors, employees and others can be paid on time. If a business or person does not have enough cash to support its operations, it is said to be insolvent, and a likely candidate for bankruptcy should the insolvency continue. The statement of cash flow reports the movement of cash into and out of your business in a given year. Cash is the lifeblood of your company. Cash includes currency, checks on hand, and deposits in banks. Cash equivalents are short-term, temporary investments such as treasury bills, certificates of deposit, or commercial paper that can be quickly and easily converted to cash. Your business will use cash to pay bills, repay loans, and make investments, allowing you to provide goods and services to your customers. Your company will use cash to generate even more cash as a result of higher profits. The cash flow statement reports your business' sources and uses of cash and the beginning and ending values for cash and cash equivalents each year. It also includes the combined total change in cash and cash equivalents from all sources and uses of cash. A cash flow calculation example is as follows. Lets say Randy's new start up company has an investment requiring $30000, To participate Randy's company must allocate this amount from its budget resulting in a 8% cost of capital.
The time span concludes in 5 years. In order to make a reasonable profit a minimum cash flow of $7513.69 would be required per year.
Number of Years (N) = 5
PV (PVA) of Cash Flows = 30000
Disc. Rate/Cost of Capital = 8%
PMT (Required Cash Flow Per Year) = $7,513.69
The fundamental difference between the classical approach to project capital investing and budgeting, and contemporary practices, is the recognition of the need to employ systems that underpin the delivery of shareholder value.
By factoring cost of capital metrics (what companies need to return to investors and lenders) into discounting formulae such as Net Present Value (NPV) companies are effectively and efficiently enabled to identify satisfactory returns. Compensating managers to achieve in excess of the shareholder return requirement is another key element of the modern approach.
Shareholders want managers to invest only if the expected rate of return exceeds the cost of capital. Because of this managers cannot ignore the cost of capital imperative and indeed their focus should be on returns over and above the cost of capital. This has given rise to a growing number of companies using EVA in manager compensation packages, especially since it resolves agency problems and generates incentives for managers to focus on increasing shareholder wealth.
It is hoped that this discussion on capital budgeting and investing will have served to better illustrate the scope of this often complex subject.
Ansari, Shahid. The Capital Budgeting Process. New York: McGraw-Hill/Irwin; 1 edition, 2000.
Boness, A J. Capital budgeting;: The public and private sectors (New directions in management and economics). Boston: Boness, 1972.
Seitz, Neil., and Mitch E. Ellison. Capital Budgeting and Long-Term Financing Decisions. Houston: South-Western College Pub; 4 edition, 2004.
McCracken, M. E. (2005). Capital budgeting. Retrieved July 18, 2006 from http://teachmefinance.com/capitalbudgeting.html