What is Capital Budgeting

Capital budgeting is the process in which a business determines and

evaluates potential large expenses or investments. These expenditures
and investments include projects such as building a new plant or
investing in a long-term venture. Often, a company assesses a
prospective project's lifetime cash inflows and outflows to determine
whether the potential returns generated meet a sufficient
target benchmark, also known as "investment appraisal."
Capital Budgeting

BREAKING DOWN Capital Budgeting

Ideally, businesses should pursue all projects and opportunities that
enhance shareholder value. However, because the amount of capital
available for new projects is limited, management needs to use capital
budgeting techniques to determine which projects will yield the most
return over an applicable period. Various methods of capital budgeting
can include throughput analysis, net present value, internal rate of
return, discounted cash flow and payback period.

There are three popular methods for deciding which projects should
receive investment funds over other projects. These methods are
throughput analysis, DCF analysis and payback period analysis.

Capital Budgeting with Throughput Analysis

One measures throughput as the amount of material passing through a
system. Throughput analysis is the most complicated form of capital
budgeting analysis, but is also the most accurate in helping managers
decide which projects to pursue. Under this method, the entire company
is a single, profit-generating system.

The analysis assumes that nearly all costs in the system are operating
expenses, that a company needs to maximize the throughput of the
entire system to pay for expenses, and that the way to maximize profits
is to maximize the throughput passing through a bottleneck operation. A
bottleneck is the resource in the system that requires the longest time in
operations. This means that managers should always place higher
consideration on capital budgeting projects that impact and increase
throughput passing though the bottleneck.
Capital Budgeting Using DCF Analysis
DCF analysis is similar or the same to NPV analysis in that it looks at the
initial cash outflow needed to fund a project, the mix of cash inflows in
the form of revenue, and other future outflows in the form of
maintenance and other costs. These costs, save for the initial outflow,
are discounted back to the present date. The resulting number of the
DCF analysis is the NPV. Projects with the highest NPV should rank
over others unless one or more are mutually exclusive.

The Most Simple Form of Capital Budgeting

Payback analysis is the simplest form of capital budgeting analysis and
is therefore the least accurate. However, managers still use this
method because it's quick and can give managers a "back of the napkin"
understanding of the efficacy of a project or group of projects. This
analysis calculates how long it will take to recoup the investment of a
project. One can identify the payback period by dividing the initial
investment by the average yearly cash inflow.

WIKIPEDIA
Capital budgeting, and investment appraisal, is the planning process used to determine
whether an organization's long term investments such as new machinery, replacement of
machinery, new plants, new products, and research development projects are worth the
funding of cash through the firm's capitalization structure (debt, equity or retained earnings).
It is the process of allocating resources for major capital, or investment, expenditures.[1] One
of the primary goals of capital budgeting investments is to increase the value of the firm to
the shareholders.
Many formal methods are used in capital budgeting, including the techniques such as

 Accounting rate of return

 Average accounting return
 Payback period
 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annual cost
 Real options valuation
These methods use the incremental cash flows from each potential investment, or project.
Techniques based on accounting earnings and accounting rules are sometimes used -
though economists consider this to be improper - such as the accounting rate of return, and
 "return on investment." Simplified and hybrid methods are used as well, such as payback
period and discounted payback period.

Contents

 1Net present value

 2Internal rate of return
 3Equivalent annuity method
 4Real options
 5Ranked projects
 6Funding sources
 7Need
 8See also
 9External links and references

Net present value[edit]

Main article: Net present value

Cash flows are discounted at the cost of capital to give the net present value (NPV) added
to the firm. Unless capital is constrained, or there are dependencies between projects, in
order to maximize the value added to the firm, the firm would accept all projects with
positive NPV. This method accounts for the time value of money.
Mutually exclusive projects are a set of projects from which at most one will be accepted, for
example, a set of projects which accomplish the same task. Thus when choosing between
mutually exclusive projects, more than one of the projects may satisfy the capital budgeting
criterion, but only one project can be accepted.

Internal rate of return[edit]

Main article: Internal rate of return

The internal rate of return (IRR) is the discount rate that gives a net present value (NPV)
of zero. It is a widely used measure of investment efficiency. To maximize return, sort
projects in order of IRR.
Many projects have a simple cash flow structure, with a negative cash flow at the start, and
subsequent cash flows are positive. In such a case, if the IRR is greater than the cost of
capital, the NPV is positive, so for non-mutually exclusive projects in an unconstrained
environment, applying this criterion will result in the same decision as the NPV method.
An example of a project with cash flows which do not conform to this pattern is a loan,
consisting of a positive cash flow at the beginning, followed by negative cash flows later.
The greater the IRR of the loan, the higher the rate the borrower must pay, so clearly, a
lower IRR is preferable in this case. Any such loan with IRR less than the cost of capital has
a positive NPV.
Excluding such cases, for investment projects, where the pattern of cash flows is such that
the higher the IRR, the higher the NPV, for mutually exclusive projects, the decision rule of
taking the project with the highest IRR will maximize the return, but it may select a project
with a lower NPV.
In some cases, several solutions to the equation NPV = 0 may exist, meaning there is more
than one possible IRR. The IRR exists and is unique if one or more years of net investment
(negative cash flow) are followed by years of net revenues. But if the signs of the cash flows
change more than once, there may be several IRRs. The IRR equation generally cannot be
solved analytically but only via iterations.
IRR is the return on capital invested, over the sub-period it is invested. It may be impossible
to reinvest intermediate cash flows at the same rate as the IRR. Accordingly, a measure
called Modified Internal Rate of Return (MIRR) is designed to overcome this issue, by
simulating reinvestment of cash flows at a second rate of return.
Despite a strong academic preference for maximizing the value of the firm according to
NPV, surveys indicate that executives prefer to maximize returns[citation needed].

Equivalent annuity method[edit]

Main article: Equivalent annual cost

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it
by the present value of the annuity factor. It is often used when assessing only the costs of
specific projects that have the same cash inflows. In this form it is known as the equivalent
annual cost (EAC) method and is the cost per year of owning and operating an asset over
its entire lifespan.
It is often used when comparing investment projects of unequal lifespans. For example, if
project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11
years it would be improper to simply compare the net present values (NPVs) of the two
projects, unless the projects could not be repeated.
The use of the EAC method implies that the project will be replaced by an identical project.
Alternatively the chain method can be used with the NPV method under the assumption that
the projects will be replaced with the same cash flows each time. To compare projects of
unequal length, say 3 years and 4 years, the projects are chained together, i.e. four
repetitions of the 3-year project are compare to three repetitions of the 4-year project. The
chain method and the EAC method give mathematically equivalent answers.
The assumption of the same cash flows for each link in the chain is essentially an
assumption of zero inflation, so a real interest rate rather than a nominal interest rate is
commonly used in the calculations.

Real options[edit]
Main article: Real options analysis

Real options analysis has become important since the 1970s as option pricing models have
gotten more sophisticated. The discounted cash flow methods essentially value projects as
if they were risky bonds, with the promised cash flows known. But managers will have many
choices of how to increase future cash inflows, or to decrease future cash outflows. In other
words, managers get to manage the projects - not simply accept or reject them. Real
options analysis tries to value the choices - the option value - that the managers will have in
the future and adds these values to the NPV.

Ranked projects[edit]
The real value of capital budgeting is to rank projects. Most organizations have many
projects that could potentially be financially rewarding. Once it has been determined that a
particular project has exceeded its hurdle, then it should be ranked against peer projects
(e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects
should be implemented until the budgeted capital has been expended.

Funding sources[edit]
Capital budgeting investments and projects must be funded through excess cash provided
through the raising of debt capital, equity capital, or the use of retained earnings. Debt
capital is borrowed cash, usually in the form of bank loans, or bonds issued to creditors.
Equity capital are investments made by shareholders, who purchase shares in the
company's stock. Retained earnings are excess cash surplus from the company's present
and past earnings.

Need[edit]

1. A large sum of money is involved which influences the profitability of the firm making
capital budgeting an important task.
2. Long term investments, once made, cannot be reversed without a significant loss of
invested capital. The investment becomes sunk, and mistakes, rather than being
readily rectified, must often be borne until the firm can be withdrawn through
depreciation charges or liquidation. It influences the whole conduct of the business
for the years to come.
3. Investment decisions are the based on which the profit will be earned and probably
measured through the return on the capital. A proper mix of capital investment is
quite important to ensure adequate rate of return on investment, calling for the need
of capital budgeting.
4. The implication of long term investment decisions are more extensive than those of
short run decisions because of time factor involved, capital budgeting decisions are
subject to the higher degree of risk and uncertainty than short run decision. [2]

METHODS

Accounting rate of return

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This article is about a capital budgeting concept. For other uses, see ARR.
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Accounting rate of return, also known as the Average rate of return, or ARR is a financial
ratio used in capital budgeting.[1] The ratio does not take into account the concept of time value of
money. ARR calculates the return, generated from net income of the proposed capital investment.
The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to
earn seven cents out of each dollar invested (yearly). If the ARR is equal to or greater than the
required rate of return, the project is acceptable. If it is less than the desired rate, it should be
rejected. When comparing investments, the higher the ARR, the more attractive the investment.
More than half of large firms calculate ARR when appraising projects.[2]
The key advantage of ARR is that it is easy to compute and understand. The main disadvantage of
ARR is that it disregards the time factor in terms of time value of money or risks for long term
investments. The ARR is built on evaluation of profits and it can be easily manipulated with changes
in depreciation methods. The ARR can give misleading information when evaluating investments of
different size.[3]

Average accounting return

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The average accounting return (AAR) is the average project earnings after taxes and depreciation,
divided by the average book value of the investment during its life. Approach to making capital
budgeting decisions involves the average accounting return (AAR). There are many different
definitions of the AAR. However, in one form or another, the AAR is always defined as: Some
measure of average accounting profit divided by some measure of average accounting value. The
specific definition we will use is: Average net income divided by Average book value. It is kinds of
decision rule to accept or reject the finance project. For decide to these projects value, it needs
cutoff rate. This rate is kind of deadline whether this project produces net income or net loss. [1]
There are three steps to calculating the AAR.
First, determine the average net income of each year of the project's life. Second, determine the
average investment, taking depreciation into account. Third, determine the AAR by dividing the
average net income by the average investment. After determine the AAR, compare with target cutoff
rate. For example, if AAR determined is 20%, and given cutoff rate is 25%, then this project should
be rejected. Because AAR is lower than cutoff rate so this project will not make sufficient net income
to cover initial cost. Average accounting return(AAR) does have advantages and disadvantages.
Advantages; It is easier to calculate than other capital budgeting decision rules. It only needs net
income data and book values of the investment during its life. Another advantage is needed
information will usually be available. Disadvantage; it does not take time value of money into
account. When we average figures that occur at different times, we are treating the near future and
the more distant future in the same way. Therefore, there is no clear indication of profitability. Also
the use of an arbitrary benchmark cutoff rate is a disadvantage. The last disadvantage is it is based
on accounting net income and book values, not cash flows and market values.

Payback period
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Payback period in capital budgeting refers to the period of time required to recoup the funds
expended in an investment, or to reach the break-even point. [1] For example, a $1000 investment
made at the start of year 1 which returned $500 at the end of year 1 and year 2 respectively would
have a two-year payback period. Payback period is usually expressed in years. Starting from
investment year by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow
Year 1 - Cash Outflow Year 1. Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash
Flow Year 2 + Net Cash Flow Year 3, etc.) Accumulate by year until Cumulative Cash Flow is a
positive number: that year is the payback year.
The time value of money is not taken into account. Payback period intuitively measures how long
something takes to "pay for itself." All else being equal, shorter payback periods are preferable to
longer payback periods. Payback period is popular due to its ease of use despite the recognized
limitations described below.
The term is also widely used in other types of investment areas, often with respect to energy
efficiency technologies, maintenance, upgrades, or other changes. For example, a compact
fluorescent light bulb may be described as having a payback period of a certain number of years or
operating hours, assuming certain costs. Here, the return to the investment consists of reduced
operating costs. Although primarily a financial term, the concept of a payback period is occasionally
extended to other uses, such as energy payback period[2][3] (the period of time over which the energy
savings of a project equal the amount of energy expended since project inception); these other
terms may not be standardized or widely used.
Purpose[edit]
Payback period as a tool of analysis is often used because it is easy to apply and easy to
understand for most individuals, regardless of academic training or field of endeavor. When
used carefully or to compare similar investments, it can be quite useful. As a stand-alone
tool to compare an investment to "doing nothing," payback period has no explicit criteria for
decision-making (except, perhaps, that the payback period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and
qualifications for its use, because it does not account for the time value of
money, risk, financing, or other important considerations, such as the opportunity cost.
Whilst the time value of money can be rectified by applying a weighted average cost of
capital discount, it is generally agreed that this tool for investment decisions should not be
used in isolation. Alternative measures of "return" preferred by economists are net present
value and internal rate of return. An implicit assumption in the use of payback period is that
returns to the investment continue after the payback period. Payback period does not
specify any required comparison to other investments or even to not making an investment.

Net present value

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In finance, the net present value (NPV) or net present worth (NPW)[1] applies to a series
of cash flows occurring at different times. The present value of a cash flow depends on the
interval of time between now and the cash flow. It also depends on the discount rate. NPV
accounts for the time value of money. It provides a method for evaluating and comparing
capital projects or financial products with cash flows spread over time, as in loans,
investments, payouts from insurance contracts plus many other applications.
Time value of money dictates that time affects the value of cash flows. For example, a
lender may offer 99 cents for the promise of receiving $1.00 a month from now, but the
promise to receive that same dollar 20 years in the future would be worth much less today
to that same person (lender), even if the payback in both cases was equally certain. This
decrease in the current value of future cash flows is based on a chosen rate of
return (or discount rate). If for example there exists a time series of identical cash flows, the
cash flow in the present is the most valuable, with each future cash flow becoming less
valuable than the previous cash flow. A cash flow today is more valuable than an identical
cash flow in the future[2] because a present flow can be invested immediately and begin
earning returns, while a future flow cannot.
Net present value (NPV) is determined by calculating the costs (negative cash flows) and
benefits (positive cash flows) for each period of an investment. The period is typically one
year, but could be measured in quarter-years, half-years or months. After the cash flow for
each period is calculated, the present value (PV) of each one is achieved by discounting its
future value (see Formula) at a periodic rate of return (the rate of return dictated by the
market). NPV is the sum of all the discounted future cash flows. Because of its simplicity,
NPV is a useful tool to determine whether a project or investment will result in a net profit or
a loss. A positive NPV results in profit, while a negative NPV results in a loss. The NPV
measures the excess or shortfall of cash flows, in present value terms, above the cost of
funds.[3] In a theoretical situation of unlimited capital budgeting a company should pursue
every investment with a positive NPV. However, in practical terms a company's capital
constraints limit investments to projects with the highest NPV whose cost cash flows, or
initial cash investment, do not exceed the company's capital. NPV is a central tool
in discounted cash flow (DCF) analysis and is a standard method for using the time value of
money to appraise long-term projects. It is widely used throughout economics, finance,
and accounting.
In the case when all future cash flows are positive, or incoming (such as
the principal and coupon payment of a bond) the only outflow of cash is the purchase price,
the NPV is simply the PV of future cash flows minus the purchase price (which is its own
PV). NPV can be described as the "difference amount" between the sums of discounted
cash inflows and cash outflows. It compares the present value of money today to the
present value of money in the future, taking inflation and returns into account.
The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or
discount curve and outputs a present value, which is the current fair price. The converse
process in discounted cash flow (DCF) analysis takes a sequence of cash flows and a price
as input and as output the discount rate, or internal rate of return (IRR) which would yield
the given price as NPV. This rate, called the yield, is widely used in bond trading.
Many computer-based spreadsheet programs have built-in formulae for PV and NPV.
 Contents

 1Formula
 2The discount rate
 3Use in decision making
 4Interpretation as integral transform
 5Example
 6Common pitfalls
 7History
 8Alternative capital budgeting methods
 9See also
 10References

Profitability index
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Corporate finance
 Working capital

 Cash conversion cycle

 Return on capital
 Economic value added
 Just-in-time
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 Discounts and allowances
 Factoring

Sections

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 Financial accounting
 Management accounting
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 Balance sheet analysis
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 Corporate action

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Profitability index (PI), also known as profit investment ratio (PIR) and value investment
ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking
projects because it allows you to quantify the amount of value created per unit of investment.
The ratio is calculated as follows:

Assuming that the cash flow calculated does not include the investment made in the project, a
profitability index of 1 indicates breakeven. Any value lower than one would indicate that the project's
present value (PV) is less than the initial investment. As the value of the profitability index increases,
so does the financial attractiveness of the proposed project.
Rules for selection or rejection of a project:

 If PI > 1 then accept the project

 If PI < 1 then reject the project
For example:

 Investment = $40,000
 Life of the Machine = 5 Years

CFAT Year CFAT

1 18000
2 12000
3 10000
4 9000
5 6000

Calculate Net present value at 10% and PI:

Year CFAT PV@10% PV

1 18000 0.909 16362

2 12000 0.827 9924
3 10000 0.752 7520
4 9000 0.683 6147
5 6000 0.621 3726
Total present value 43679
(-) Investment 40000
NPV 3679

PI = 43679/40000 = 1.091 > 1 ⇒ Accept the project

Definition[edit]
The internal rate of return on an investment or project is the "annualized effective
compounded return rate" or rate of return that sets the net present value of all cash flows
(both positive and negative) from the investment equal to zero. Equivalently, it is
 the discount rate at which the net present value of the future cash flows is equal to the initial
investment, and it is also the discount rate at which the total present value of costs
(negative cash flows) equals the total present value of the benefits (positive cash flows).
Speaking intuitively, IRR is designed to account for the time preference of money and
investments. A given return on investment received at a given time is worth more than the
same return received at a later time, so the latter would yield a lower IRR than the former, if
all other factors are equal. A fixed income investment in which money is deposited
once, interest on this deposit is paid to the investor at a specified interest rate every time
period, and the original deposit neither increases nor decreases, would have an IRR equal
to the specified interest rate. An investment which has the same total returns as the
preceding investment, but delays returns for one or more time periods, would have a lower
IRR

Modified internal rate of return

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The modified internal rate of return (MIRR) is a financial measure of an investment's

attractiveness.[1][2] It is used in capital budgeting to rank alternative investments of equal size. As the
name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve
some problems with the IRR.

Contents

 1Problems with the IRR

 2Calculation of the MIRR
o 2.1Example
 3Comparing projects of different sizes
 4References

Problems with the IRR[edit]

While there are several problems with the IRR, MIRR resolves two of them.
Firstly, IRR is sometimes misapplied, under an assumption that interim positive cash flows are
reinvested at the same rate of return as that of the project that generated them.[3] This is usually an
unrealistic scenario and a more likely situation is that the funds will be reinvested at a rate closer to
the firm's cost of capital. The IRR therefore often gives an unduly optimistic picture of the projects
under study. Generally for comparing projects more fairly, the weighted average cost of
capital should be used for reinvesting the interim cash flows.
Secondly, more than one IRR can be found for projects with alternating positive and negative cash
flows, which leads to confusion and ambiguity. MIRR finds only one value.
Equivalent annual cost
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In finance, the equivalent annual cost (EAC) is the cost per year of owning and operating an asset
over its entire lifespan. It is calculated by dividing the NPV of a project by the "present value
of annuity factor":

, where
where r is the annual interest rate and
t is the number of years.
Alternatively, EAC can be obtained by multiplying the NPV of the project by the "loan repayment
factor".
EAC is often used as a decision making tool in capital budgeting when comparing investment
projects of unequal lifespans. However, the projects being compared must have equal risk:
otherwise, EAC must not be used.[1]
The technique was first discussed in 1923 in engineering literature,[2] and, as a consequence, EAC
appears to be a favoured technique employed by engineers, while accountantstend to prefer net
present value (NPV) analysis.[3] Such preference has been described as being a matter of
professional education, as opposed to an assessment of the actual merits of either method.[4] In the
latter group, however, the Society of Management Accountants of Canada endorses EAC, having
discussed it as early as 1959 in a published monograph[5] (which was a year before the first mention
of NPV in accounting textbooks).[6]

Real options valuation

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Real options valuation, also often termed real options analysis,[1] (ROV or ROA)
applies option valuation techniques to capital budgeting decisions.[2] A real option itself, is the
right—but not the obligation—to undertake certain business initiatives, such as deferring,
abandoning, expanding, staging, or contracting a capital investment project. For example, the
opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a
real call or put option, respectively.[3]
Real options are generally distinguished from conventional financial options in that they are not
typically traded as securities, and do not usually involve decisions on an underlying asset that is
traded as a financial security.[4] A further distinction is that option holders here, i.e. management, can
directly influence the value of the option's underlying project; whereas this is not a consideration as
regards the underlying security of a financial option. Moreover, management cannot measure
uncertainty in terms of volatility, and must instead rely on their perceptions of uncertainty. Unlike
financial options, management also have to create or discover real options, and such creation and
discovery process comprises an entrepreneurial or business task. Real options are most valuable
when uncertainty is high; management has significant flexibility to change the course of the project in
a favorable direction and is willing to exercise the options.[5]
Real options analysis, as a discipline, extends from its application in corporate finance, to decision
making under uncertainty in general, adapting the techniques developed for financial options to
 "real-life" decisions. For example, R&D managers can use Real Options Valuation to help them
allocate their R&D budget among diverse projects; a non business example might be the decision to
join the work force, or rather, to forgo several years of income to attend graduate school.[6] It, thus,
forces decision makers to be explicit about the assumptions underlying their projections, and for this
reason ROV is increasingly employed as a tool in business strategy formulation.[7][8] This extension of
real options to real-world projects often requires customized decision support systems, because
otherwise the complex compound real options will become too intractable to handle.[9]

Capital Budgeting: The

Importance Of Capital
Budgeting
By Sham Gad

1. Capital
Budgeting:
Introduction
2. Capital
Budgeting:
The
Importance
Of Capital
Budgeting
3. Capital
Budgeting:
Evaluating
The
Desirability
Of An
Investment
4. Capital
Budgeting:
Capital
Budgeting
Decision
 Tools
5. Capital
Budgeting:
The Capital
Budgeting
Process At
Work
6. Capital
Budgeting:
Wrapping It
All Up

Capital budgeting is a step by step process that businesses use to

determine the merits of an investment project. The decision of whether
to accept or deny an investment project as part of a company's growth
initiatives, involves determining the investment rate of return that such a
project will generate. However, what rate of return is deemed acceptable
or unacceptable is influenced by other factors that are specific to the
company as well as the project. For example, a social or charitable
project is often not approved based on rate of return, but more on the
desire of a business to foster goodwill and contribute back to its
community.

Capital budgeting is important because it creates accountability and

measurability. Any business that seeks to invest its resources in a
project, without understanding the risks and returns involved, would be
held as irresponsible by its owners or shareholders. Furthermore, if a
business has no way of measuring the effectiveness of its investment
decisions, chances are that the business will have little chance of
surviving in the competitive marketplace.

Businesses (aside from non-profits) exist to earn profits. The capital

budgeting process is a measurable way for businesses to determine the
long-term economic and financial profitability of any investment project.
Capital budgeting is also vital to a business because it creates a
structured step by step process that enables a company to:

1. Develop and formulate long-term strategic goals – the ability to

set long-term goals is essential to the growth and prosperity of any
business. The ability to appraise/value investment projects via
capital budgeting creates a framework for businesses to plan out
future long-term direction.

2. Seek out new investment projects – knowing how to evaluate

investment projects gives a business the model to seek and
evaluate new projects, an important function for all businesses as
they seek to compete and profit in their industry.

3. Estimate and forecast future cash flows – future cash flows are
what create value for businesses overtime. Capital budgeting
enables executives to take a potential project and estimate its
future cash flows, which then helps determine if such a project
should be accepted.

4. Facilitate the transfer of information – from the time that a

project starts off as an idea to the time it is accepted or rejected,
numerous decisions have to be made at various levels of authority.
The capital budgeting process facilitates the transfer of information
to the appropriate decision makers within a company.

5. Monitoring and Control of Expenditures – by definition a budget

carefully identifies the necessary expenditures and R&D required
for an investment project. Since a good project can turn bad if
expenditures aren't carefully controlled or monitored, this step is a
crucial benefit of the capital budgeting process.

6. Creation of Decision – when a capital budgeting process is in

place, a company is then able to create a set of decision rules that
can categorize which projects are acceptable and which projects
are unacceptable. The result is a more efficiently run business that
is better equipped to quickly ascertain whether or not to proceed
 further with a project or shut it down early in the process, thereby
saving a company both time and money.

Unlike other business decisions that involve a singular aspect of a

business, a capital budgeting decision involves two important decisions
at once: a financial decision and an investment decision. By taking on a
project, the business has agreed to make a financial commitment to a
project, and that involves its own set of risks. Projects can run into
delays, cost overruns and regulatory restrictions that can all delay or
increase the projected cost of the project.

In addition to a financial decision, a company is also making an

investment in its future direction and growth that will likely have an
influence on future projects that the company considers and evaluates.
So to make a capital investment decision only from the perspective of
either a financial or investment decisions can pose serious limitations on
the success of the project.

In December 2009 ExxonMobil, the world's largest oil company,

announced that it was acquiring XTO Resources, one of the largest
natural gas companies in the U.S. for $41 billion. That acquisition was a
capital budgeting decision, one in which ExxonMobil made a huge
financial commitment. But in addition, ExxonMobil was making a
significant investment decision in natural gas and essentially positioning
the company to also focus on growth opportunities in the natural gas
arena. That acquisition alone will have a profound effect on future
projects that ExxonMobil considers and evaluates for many years to
come.

The significance of these dual decisions is profound for companies.

Executives have been known to lose jobs over poor investment
decisions. One can say that running a business is nothing more than a
constant exercise in capital budgeting decisions. Understanding that
both a financial and investment decision is being made is paramount to
making successful capital investment decisions.
 Types of Capital Investment Projects

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BY ROSEMARY PEAVLER

Updated January 10, 2019

Analyzing different types of capital investment projects and investing in the most
profitable projects is what gives life and growth to a company. Unless a company
conducts the necessary research and development to develop new products, to
improve existing products or services, and to discover ways to operate more
efficiently, that company and the economy in which it operates will stagnate.

Companies of any size and entrepreneurs starting a new business should have a
Research and Development Department. That department, along with usually a
committee composed of finance, marketing, technology, and other executives are
charged with coming up with ideas to improve the company and the products and
services offered by the company.

Research and development are not free to a company. It is a cost/benefit

operation. Well-managed firms go to great lengths to develop good capital
budgeting proposals that provide value to the firm and the economy at large.
There are numerous types of capital budgeting projects. Let's look at a few of
them.

 01

New Products or New Markets

Thomas Barwick/Stone/Getty Images

A new capital investment project is important for the growth and expansion of a
company. It is also important for the economy at large as it means research and
development. This type of project is one that is either for expansion into a new
product line or a new product market, often called the target market.

A new product or a new target market could, conceivably, change the nature of
the business. It should be approved by higher-ups in the business organization.
A new project, either a new product or a new target market, requires a detailed
financial analysis and the approval of possibly even the firm's Board of Directors.

An example of a new product would be a new medical device that is conceived,

researched and developed by a company specializing in medical devices.
Perhaps this medical device would tap into a target market that the company had
not yet been able to reach.

 02

Expansion of Existing Products or Markets

The expansion of existing products or target markets means an expansion of the

business. If a company undertakes this kind of capital budgeting product, they
are effectively acknowledging a surge in growth of demand.

A detailed financial analysis is required, but not as detailed as that required for
the expansion of the company into new products or new target markets.

 03

Replacement Project Necessary to Continue Operations as Usual

An example of a replacement project necessary to continue operations as usual
would be, for example, replacing a worn out piece of equipment with a new piece
of the same equipment designed to do the same job in a manufacturing plant.

It is a simple capital budgeting project to evaluate. It would be possible to use

one of these simpler capital budgeting methods to evaluate this project and abide
by the decision of the capital budgeting method.

The cash flows from a replacement project necessary to continue operations, as

usual, are fairly easy to estimate, at least compared to other types of projects,
because the business owner is replacing the same type of equipment and is,
therefore, somewhat familiar with it.

 04

Replacement Project Necessary to Reduce Business Costs

During the Great Recession, many companies have been looking at this type of
capital project. Sometimes, businesses need to replace some projects with
others to reduce costs. An example would be replacing a piece of obsolete
equipment with a more modern piece of equipment that is easier to have
serviced.

This type of capital budgeting project would require a detailed financial analysis
with cash flows estimated from each piece of equipment to determine which
generates the most in cash flows and, thus, saves money. These are the four
basic types of capital budgeting projects, although there are offshoots of each
one.

Types of Capital Investment Projects

o Share
 o Pin

o Email

BY ROSEMARY PEAVLER

Updated January 10, 2019

Analyzing different types of capital investment projects and investing in the most
profitable projects is what gives life and growth to a company. Unless a company
conducts the necessary research and development to develop new products, to
improve existing products or services, and to discover ways to operate more
efficiently, that company and the economy in which it operates will stagnate.

Companies of any size and entrepreneurs starting a new business should have a
Research and Development Department. That department, along with usually a
committee composed of finance, marketing, technology, and other executives are
charged with coming up with ideas to improve the company and the products and
services offered by the company.

Research and development are not free to a company. It is a cost/benefit

operation. Well-managed firms go to great lengths to develop good capital
budgeting proposals that provide value to the firm and the economy at large.
There are numerous types of capital budgeting projects. Let's look at a few of
them.

 01

New Products or New Markets

Thomas Barwick/Stone/Getty Images

A new capital investment project is important for the growth and expansion of a
company. It is also important for the economy at large as it means research and
development. This type of project is one that is either for expansion into a new
product line or a new product market, often called the target market.

A new product or a new target market could, conceivably, change the nature of
the business. It should be approved by higher-ups in the business organization.
A new project, either a new product or a new target market, requires a detailed
financial analysis and the approval of possibly even the firm's Board of Directors.

An example of a new product would be a new medical device that is conceived,

researched and developed by a company specializing in medical devices.
Perhaps this medical device would tap into a target market that the company had
not yet been able to reach.

 02

Expansion of Existing Products or Markets

The expansion of existing products or target markets means an expansion of the

business. If a company undertakes this kind of capital budgeting product, they
are effectively acknowledging a surge in growth of demand.

A detailed financial analysis is required, but not as detailed as that required for
the expansion of the company into new products or new target markets.

 03

Replacement Project Necessary to Continue Operations as Usual

An example of a replacement project necessary to continue operations as usual

would be, for example, replacing a worn out piece of equipment with a new piece
of the same equipment designed to do the same job in a manufacturing plant.
It is a simple capital budgeting project to evaluate. It would be possible to use
one of these simpler capital budgeting methods to evaluate this project and abide
by the decision of the capital budgeting method.

The cash flows from a replacement project necessary to continue operations, as

usual, are fairly easy to estimate, at least compared to other types of projects,
because the business owner is replacing the same type of equipment and is,
therefore, somewhat familiar with it.

 04

Replacement Project Necessary to Reduce Business Costs

During the Great Recession, many companies have been looking at this type of
capital project. Sometimes, businesses need to replace some projects with
others to reduce costs. An example would be replacing a piece of obsolete
equipment with a more modern piece of equipment that is easier to have
serviced.

This type of capital budgeting project would require a detailed financial analysis
with cash flows estimated from each piece of equipment to determine which
generates the most in cash flows and, thus, saves money. These are the four
basic types of capital budgeting projects, although there are offshoots of each
one.