# 3. BASIC PRINCIPLES OF CAPITAL BUDGETING

Capital budgeting has a rich history and sometimes employs some pretty sophisticated procedures. Fortunately, capital budgeting relies on just a few basic principles. Capital budgeting usually uses the following assumptions:

1. Decisions are based on cash flows. The decisions are not based on accounting concepts, such as net income. Furthermore, intangible costs and benefits are often ignored because, if they are real, they should result in cash flows at some other time.

2. Timing of cash flows is crucial. Analysts make an extraordinary effort to detail precisely when cash flows occur.

3. Cash flows are based on opportunity costs. What are the incremental cash flows that occur with an investment compared to what they would have been without the investment?

4. Cash flows are analyzed on an after-tax basis. Taxes must be fully reflected in all capital budgeting decisions.

5. Financing costs are ignored. This may seem unrealistic, but it is not. Most of the time, analysts want to know the after-tax operating cash flows that result from a capital investment. Then, these after-tax cash flows and the investment outlays are discounted at the “required rate of return” to find the net present value (NPV). Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operating cash flows and capturing the costs of debt (and other capital) in the discount rate.

6. Capital budgeting cash flows are not accounting net income. Accounting net income is reduced by noncash charges such as accounting depreciation. Furthermore, to reflect the cost of debt financing, interest expenses are also subtracted from accounting net income. (No subtraction is made for the cost of equity financing in arriving at accounting net income.) Accounting net income also differs from economic income, which is the cash inflow plus the change in the market value of the company. Economic income does not subtract the cost of debt financing, and it is based on the changes in the market value of the company, not changes in its book value (accounting depreciation).

In assumption 5 above, we referred to the rate used in discounting the cash flows as the “required rate of return.” The required rate of return is the discount rate that investors should require given the riskiness of the project. This discount rate is frequently called the “opportunity cost of funds” or the “cost of capital.” If the company can invest elsewhere and earn a return of r, or if the company can repay its sources of capital and save a cost of r, then r is the company’s opportunity cost of funds. If the company cannot earn more than its opportunity cost of funds on an investment, it should not undertake that investment. Unless an investment earns more than the cost of funds from its suppliers of capital, the investment should not be undertaken. The cost-of-capital concept is discussed more extensively elsewhere. Regardless of what it is called, an economically sound discount rate is essential for making capital budgeting decisions.

Although the principles of capital budgeting are simple, they are easily confused in practice, leading to unfortunate decisions. Some important capital budgeting concepts that managers find very useful are given below.

• A sunk cost is one that has already been incurred. You cannot change a sunk cost. Today’s decisions, on the other hand, should be based on current and future cash flows and should not be affected by prior, or sunk, costs.

• An opportunity cost is what a resource is worth in its next-best use. For example, if a company uses some idle property, what should it record as the investment outlay: the purchase price several years ago, the current market value, or nothing? If you replace an old machine with a new one, what is the opportunity cost? If you invest $10 million, what is the opportunity cost? The answers to these three questions are, respectively: the current market value, the cash flows the old machine would generate, and$10 million (which you could invest elsewhere).

• An incremental cash flow is the cash flow that is realized because of a decision: the cash flow with a decision minus the cash flow without that decision. If opportunity costs are correctly assessed, the incremental cash flows provide a sound basis for capital budgeting.

• An externality is the effect of an investment on other things besides the investment itself. Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative. If possible, these should be part of the investment decision. Sometimes externalities occur outside of the company. An investment might benefit (or harm) other companies or society at large, and yet the company is not compensated for these benefits (or charged for the costs). Cannibalization is one externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company.

• Conventional cash flows versus nonconventional cash flows—A conventional cash flow pattern is one with an initial outflow followed by a series of inflows. In a nonconventional cash flow pattern, the initial outflow is not followed by inflows only, but the cash flows can flip from positive to negative again (or even change signs several times). An investment that involved outlays (negative cash flows) for the first couple of years that were then followed by positive cash flows would be considered to have a conventional pattern. If cash flows change signs once, the pattern is conventional. If cash flows change signs two or more times, the pattern is nonconventional.

Several types of project interactions make the incremental cash flow analysis challenging. The following are some of these interactions:

• Independent projects versus mutually exclusive projects—Independent projects are projects whose cash flows are independent of each other. Mutually exclusive projects compete directly with each other. For example, if Projects A and B are mutually exclusive, you can choose A or B, but you cannot choose both. Sometimes there are several mutually exclusive projects, and you can choose only one from the group.

• Project sequencing—Many projects are sequenced through time, so that investing in a project creates the option to invest in future projects. For example, you might invest in a project today and then in one year invest in a second project if the financial results of the first project or new economic conditions are favorable. If the results of the first project or new economic conditions are not favorable, you do not invest in the second project.

• Unlimited funds versus capital rationing—An unlimited funds environment assumes that the company can raise the funds it wants for all profitable projects simply by paying the required rate of return. Capital rationing exists when the company has a fixed amount of funds to invest. If the company has more profitable projects than it has funds for, it must allocate the funds to achieve the maximum shareholder value subject to the funding constraints.