In order to understand capital budgeting, you have to understand both parts of the term. First of all, "capital," in this context, is long-term, fixed assets, or the capital investment, used in the production of the product sold by the business. "Budget" is the plan that details planned revenue and expenses during a particular time period. The term "capital budgeting" is the process of determining which long-term capital investments should be chosen by the firm during a particular time period and included in the capital budget.
Capital Budgeting versus Budgeting for Financial Assets
The financial process for determining the value of capital investment projects, such as buying a building or a piece of equipment and determining the value of stocks and bonds is exactly the same. They are all assets in which a firm invests.
There are two differences. Businesses create capital projects, but financial assets exist in the financial markets and investors have a finite set of them to choose from. The second difference is that investors in stocks and bonds have no influence over the cash flows they produce, but a company does have influence over their capital projects through good financial management.
Mutually Exclusive and Independent Capital Investment Projects
Capital investment projects are some of the most important financial expenditures made by a business owner because they involve large amounts of money and projects that last more than a year and often several years. Making a poor capital investment decision can have a disastrous effect on a business firm and even cause business bankruptcy because it will cost so much money.
Capital investment projects can be divided up into two types: independent projects and mutually exclusive projects. Independent capital investment projects are those projects that do not affect the cash flows of other projects. Mutually exclusive capital investment projects are those projects that are the same or so similar to other capital investment projects that they do impact the cash flows of another project. The difference between these two types of investment projects is very important in capital budgeting and the financial analysis that is required to select or reject investment projects.
How is a mutually exclusive or an independent project chosen? The most important thing that a business owner absolutely must do is compare the rate of return that the project will earn to the weighted average cost of capital or what the company pays to obtain financing. The decision rule is the if the rate of return is greater than the weighted average cost of capital, then accept and invest in the project. If the rate of return of the project is less than the weighted average cost of capital, then reject and do not invest in the project.
This rate of return is actually an opportunity cost. In other words, the rate of return is the cost of investing in one project as opposed to another.
Consider These Factors when Making a Capital Investment Decision
Comparing the rate of return of a project to the weighted average cost of capital of the firm is not as simple as it sounds. There is a relatively complex financial analysis process the business owner has to go through in order to get there.
The business owner has to estimate the cash flows that will be generated by the project. Often, the cash flows are the single hardest variable to estimate when trying to determine the rate of return on the project. Both the quantity and timing of the cash flows have to be considered. If you are writing a business plan, for example, you need to estimate about five years of cash flows. As the business owner, only you can determine how far in future to estimate cash flows. Usually, cash flows are estimated for the economic life of the project and should be as accurate as possible. In addition, in capital budgeting, cash flows are stated on an after-tax basis.
There are a number of cash flow forecasting methods that business owners can use to choose their projects.