Capital budgeting is the process companies
undertake to plan, justify, and purchase
long-term capital projects.
Usually, these projects require large sums of money.
This picture is an example of items
that would require capital budgeting to acquire.
You can see the factory and some machinery, et cetera.
These assets are commonly known as long-term planning
plant assets, or capital assets, or Property, Plant,
and Equipment, P, P & E for short.
Capital budgeting analysis depends on a number of things.
I've simplified them here into three general categories--
the availability of funds to undertake
new projects, the importance and criticalness of the project,
and risk and return of a project.
Capital projects can either be standalone projects,
where there are no competing alternatives,
or the company has funds available to acquire
all the projects that meet minimum requirements,
or mutually exclusive projects, which
involve choosing from competing alternatives,
usually because funds are limited.
This concept of having to choose between various projects
because funds are limited is called capital rationing.
The data needed to complete capital budgeting
depends a little on the techniques used.
But in general, we need to look at the cash
outflows and the cash inflows created
by the potential project.
You can see some examples on the slide.
The final piece of information needed is the cost of capital.
This is the average rate a firm pays investors and creditors
for the use of money.
Firms finance capital projects with a combination
of, debt like loans and bonds, and equity, like stocks
and retained earnings.
We call the former debt financing and the latter equity
financing.
In general a project needs to create a return greater
than the capital.
For example, if you borrow $1,000
from a bank at a rate of 5% interest
and invest that in a project that earns 12%,
you would be better off doing the project
because the return is greater than the cost of funds
invested.
The capital is often referred to as WACC, which
is the Weighted Average Cost of Capital
or sometimes called the discount rate.
There are four primary methods used to do capital budgeting
techniques.
They are the payback period method, the accounting rate
of return method, net present value method,
and the internal rate of return method--
although I don't know any company doing the accounting
rate of return.
I think that might be really old-school.
So there are examples of videos on the other methods which
I strongly encourage you to watch.
Finally, here are the six steps to capital budgeting analysis.
They are, 1, identify potential projects.
2, forecast the cash inflows and outflows for the project.
3, analyze the project using appropriate capital budgeting
techniques.
For 4, choose the best from the alternatives.
5.
Apply capital rationing.
Again, this is an important concept.
Firms don't have unlimited resources,
so capital rationing basically means
which projects they can do based on the limited amount of cash.
And finally, 6, a post audit.
Usually companies go back after five years or so
and see how the actual project performance
compared to the initial budget.