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capital budgeting process: definitions, steps, main principles
Definition of Capital Budgeting for Level 1 CFA Exam Candidates
Capital budgeting is a process carried out by companies in order to make decisions on investment projects lasting more than one year. Capital budgeting is a key issue for in-house analysts because potential mistakes made during the budgeting process may affect the future of their companies.
Steps in Capital Budgeting
Capital budgeting can be divided into four steps:
- Step 1: Generating Ideas
- Step 2: Analyzing Individual Proposals
- Step 3: Planning the Capital Budget
- Step 4: Monitoring and Post-Auditing
The step called Generating Ideas is the most important part of the budgeting process. At this stage, ideas for future investment projects are born. These ideas can come from each department of the company but they can also come from the outside.
The next step called Analyzing Individual Proposals is about gathering information in order to estimate future cash flows and assess the profitability of individual projects.
The Planning the Capital Budget step, involves choosing profitable projects so that they fit the company's strategy.
In the Monitoring and Post-Auditing step, you compare the actual results of investments with the planned or predicted results and you explain any differences. This ex-post audit allows you to monitor the forecasts and analyses that underlie the capital budgeting process and improve company performance. It also allows you to respond if sales or costs are out of line.
Categories of Investment Projects
There are different classifications of projects. One such classification would be as follows:
- replacement projects,
- expansion projects,
- new products and services,
- regulatory, safety, and environmental projects,
- high-risk projects that are not subject to traditional evaluation methods such as the net present value or the so-called pet projects.
Capital Budgeting - More Definitions
A sunk cost is the cost that has been incurred and can’t be changed. Today’s decisions shouldn’t be based on costs incurred earlier, i.e. sunk costs.
An opportunity cost is an incurred cost and a result of a particular choice. It shows you the benefit that would be achieved if you chose a different solution. If you replace an old machine with a new one, an opportunity cost is (i) a cash flow generated by the machine which you got rid of, and (ii) any possible profits from the investment of additional money dedicated for the purchase of a new machine.
Incremental cash flow
An incremental cash flow is equal to the difference between the cash flow if we undertake the project and the cash flow if we don’t undertake the project.
Externalities are factors that influence an investment and which are not directly related to the project. They can be both positive and negative, and they can come from the company or from the outside. An example of externality is cannibalization, i.e. a situation in which the benefits of the investment project adversely affect revenues from other activities of the company.
Conventional cash flow pattern vs. Nonconventional cash flow pattern
A conventional cash flow pattern is one with an initial outflow followed by a series of inflows. In the case of nonconventional cash flow patterns, outflows appear more than once and are interwoven with inflows.
Question 1: Capital Budgeting Question
Which of the statements about capital budgeting process is least likely correct?
- Cannibalization is an example of externality.
- Nonconventional projects are projects with at least one cash flow sign change.
- When analyzing a new investment project, an analyst should focus on future and current cash flows only and not on past cash flows.
Statement B is incorrect.
Nonconventional projects are projects with at least two cash flow sign changes. If we have only one change in the project cash flows (from investment outlay(s) to cash inflow(s)), we deal with a conventional project.
Statement A is correct.
Externalities related to a given project can occur inside the company or outside of it and their impact can be either positive or negative.
If externalities occur outside of the company, it means the investment impacts the environment or society or other companies, etc.
If externalities occur inside the company, it means the investment impacts the company's cash flows not related to the project, e.g. cannibalization, which is when a given investment takes sales away from other investments of the company.
Statement C is correct.
When analyzing a new investment project, an analyst should focus on future and current cash flows only and not on past cash flows and costs. These past costs are called sunk costs and shouldn’t be taken into consideration when evaluating investment projects.
Question 2: Capital Budgeting Question
At which of the following capital budgeting steps does a company consider the timing of the projects or schedule and prioritize them?
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Level 1 CFA Exam: Main Principles of Capital Budgeting
We can distinguish several universal principles on which the evaluation of investment projects is based. These principles apply to cash flows and the discount rate. When taking your Level 1 CFA Exam remember:
In order to evaluate investment projects, you use after-tax operating cash flows which you place at certain moments in time and you discount them at the interest rate which takes into account capital costs and financing costs.
If you wanted to develop this further, you should remember that:
- All decisions are based on cash flows rather than income statement’s accounts, such as net income.
- A very important factor is the right placement of cash flows over time because whether the project is profitable or not depends on it.
- Cash flows are considered in the context of opportunity costs. Incremental cash flows achieved through an investment are compared with cash flows that would occur without undertaking the investment.
- After-tax cash-flows are analyzed. Taxes must be considered when making any investment decisions.
- Financing costs are not reflected in cash flows but in the required rate of return. Therefore, we take into account cash flows from operating activities and the discount rate includes financing costs.
Mutually Exclusive Projects, Project Sequencing, Capital Availability:
Impact on Investment Projects Analysis
In the case of independent projects, cash flows of individual projects aren’t dependent on each other and projects can be carried out simultaneously. When it comes to mutually exclusive projects, it isn’t possible to simultaneously carry out different projects. You have to choose one of them or reject all.
Project sequencing is when many projects are sequenced through time so it is possible to invest in them at different times. Therefore you might invest in a project today and after some time invest in another project if the financial results of the first project are desirable.
If a company has unlimited funds it can carry out all the projects that provide the required rate of return.
In the case of limited funds and capital rationing, the company should choose those projects that maximize company value.
Level 1 CFA Exam Takeaways for Capital Budgeting
- Capital budgeting is a process carried out by companies in order to make decisions on investment projects lasting more than one year.
- Capital budgeting can be divided into four steps: Generating Ideas, Analyzing Individual Proposals, Planning the Capital Budget, Monitoring and Post-Auditing.
- As a result of the capital budgeting process you choose those investment projects whose implementation will contribute to the ultimate goal of the management which is to increase the value of a company for its owners, e.g. stockholders in the case of a public company.
- Today’s decisions shouldn’t be based on costs incurred earlier, i.e. sunk costs.
- Cannibalization is a situation in which the benefits of the investment project adversely affect revenues from other activities of the company.
- In order to evaluate investment projects, you use after-tax operating cash flows which you place at certain moments in time and you discount them at the interest rate which takes into account capital costs and financing costs.