Capital Budgeting

Capital Budgeting

Capital budgeting focuses on the new projects a company should accept and which it should reject. The conventional project examined in capital budgeting has three critical prerequisites: (1) a substantial up-front investment, (2) cash flows for a specific time period, and (3) a surplus value at the end, which captures the value of the assets of the project once the project ends. Even though such projects undoubtedly form a significant proportion of investment decisions, especially for manufacturing companies, it would be a foolish to assume that the investment analysis ends there. If a project is classified generally to incorporate any decision that results in employing the limited assets of a company, then everything from critical decisions to the replacement of an elevator in a building would fall within its reach.

Defined generally then, all of the following decisions would qualify as a project:

1. Strategic options to enter into new geographic areas or businesses.

2. Acquisitions and joint ventures are projects as well, despite attempts to define special rules for them.

3. Decisions on capital expansion on existing businesses or markets.

4. Decision that may change how an existing investment or projects is run including reinvestment plans or exiting the business.

5. Choices on how best to provide a service that is essential for the business to run smoothly. An excellent example would be the type of inventory management software to allow quicker item pick times and lower shipping costs. While the inventory management system by itself might not deliver revenues and profits, it is an indispensible asset for other income generating projects.

Capital budgeting decision can be classified based on a number of important factors. The first is how a project impacts other projects in the pipeline. Projects can be looked at as independent of other projects, and can be reviewed separately, whereas other projects can be compared to other similar projects with all being rejected but one – these are defined as mutually exclusive projects. On the other hand, some large scale projects are designed as prerequisites for other projects in the future and others are supporting. In general, projects can be grouped and classified anywhere between prerequisites or as mutually exclusive.

The second key factor used to classify a project is its capacity to generate revenue or cost savings. The decision to accept or reject a project is if the projected cash flows meet a specific hurdle rate or net present value. This same rule holds when it comes to cost-reduction projects, the decision rules analyze whether the reduction in cost justifies the up-front investment needed for the projects.

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