#cfa-level-1 #corporate-finance #reading-35-capital-budgeting #study-session-10

The specific capital budgeting procedures that a manager uses depend on the manager’s level in the organization, the size and complexity of the project being evaluated, and the size of the organization. The typical steps in the capital budgeting process are as follows:

  • Step One: Generating Ideas—Investment ideas can come from anywhere, from the top or the bottom of the organization, from any department or functional area, or from outside the company. Generating good investment ideas to consider is the most important step in the process.

  • Step Two: Analyzing Individual Proposals—This step involves gathering the information to forecast cash flows for each project and then evaluating the project’s profitability.

  • Step Three: Planning the Capital Budget—The company must organize the profitable proposals into a coordinated whole that fits within the company’s overall strategies, and it also must consider the projects’ timing. Some projects that look good when considered in isolation may be undesirable strategically. Because of financial and real resource issues, the scheduling and prioritizing of projects is important.

  • Step Four: Monitoring and Post-auditing—In a post-audit, actual results are compared to planned or predicted results, and any differences must be explained. For example, how do the revenues, expenses, and cash flows realized from an investment compare to the predictions? Post-auditing capital projects is important for several reasons. First, it helps monitor the forecasts and analysis that underlie the capital budgeting process. Systematic errors, such as overly optimistic forecasts, become apparent. Second, it helps improve business operations. If sales or costs are out of line, it will focus attention on bringing performance closer to expectations if at all possible. Finally, monitoring and post-auditing recent capital investments will produce concrete ideas for future investments. Managers can decide to invest more heavily in profitable areas and scale down or cancel investments in areas that are disappointing.

Planning for capital investments can be very complex, often involving many persons inside and outside of the company. Information about marketing, science, engineering, regulation, taxation, finance, production, and behavioral issues must be systematically gathered and evaluated. The authority to make capital decisions depends on the size and complexity of the project. Lower-level managers may have discretion to make decisions that involve less than a given amount of money, or that do not exceed a given capital budget. Larger and more complex decisions are reserved for top management, and some are so significant that the company’s board of directors ultimately has the decision-making authority.

Like everything else, capital budgeting is a cost–benefit exercise. At the margin, the benefits from the improved decision making should exceed the costs of the capital budgeting efforts.

Companies often put capital budgeting projects into some rough categories for analysis. One such classification would be as follows:

  1. Replacement projects. These are among the easier capital budgeting decisions. If a piece of equipment breaks down or wears out, whether to replace it may not require careful analysis. If the expenditure is modest and if not investing has significant implications for production, operations, or sales, it would be a waste of resources to overanalyze the decision. Just make the replacement. Other replacement decisions involve replacing existing equipment with newer, more efficient equipment, or perhaps choosing one type of equipment over another. These replacement decisions are often amenable to very detailed analysis, and you might have a lot of confidence in the final decision.

  2. Expansion projects. Instead of merely maintaining a company’s existing business activities, expansion projects increase the size of the business. These expansion decisions may involve more uncertainties than replacement decisions, and these decisions will be more carefully considered.

  3. New products and services. These investments expose the company to even more uncertainties than expansion projects. These decisions are more complex and will involve more people in the decision-making process.

  4. Regulatory, safety, and environmental projects. These projects are frequently required by a governmental agency, an insurance company, or some other external party. They may generate no revenue and might not be undertaken by a company maximizing its own private interests. Often, the company will accept the required investment and continue to operate. Occasionally, however, the cost of the regulatory/safety/environmental project is sufficiently high that the company would do better to cease operating altogether or to shut down any part of the business that is related to the project.

  5. Other. The projects above are all susceptible to capital budgeting analysis, and they can be accepted or rejected using the net present value (NPV) or some other criterion. Some projects escape such analysis. These are either pet projects of someone in the company (such as the CEO buying a new aircraft) or so risky that they are difficult to analyze by the usual methods (such as some research and development decisions).


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