Capital budgeting

Capital budgeting is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives. A capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other long-range major items of property. The alternative selected usually involves large sums of money and brings about a large increase in fixed costs for a number of years in the future. Once a company builds a plant or undertakes some other capital expenditure, its future plans are less flexible.

Poor capital-budgeting decisions can be costly because of the large sums of money and relatively long periods involved. If a poor capital budgeting decision is implemented, the company can lose all or part of the funds originally invested in the project and not realize the expected benefits. In addition, other actions taken within the company regarding the project, such as finding suppliers of raw materials, are wasted if the capital-budgeting decision must be revoked. Poor capital-budgeting decisions may also harm the company’s competitive position because the company does not have the most efficient productive assets needed to compete in world markets.

Investment of funds in a poor alternative can create other problems as well. Workers hired for the project might be laid off if the project fails, creating morale and unemployment problems. Many of the fixed costs still remain even if a plant is closed or not producing. For instance, advertising efforts would be wasted, and stock prices could be affected by the decline in income.

On the other hand, failure to invest enough funds in a good project also can be costly. Ford’s Mustang is an excellent example of this problem. At the time of the original capital-budgeting decision, if Ford had correctly estimated the Mustang’s popularity, the company would have expended more funds on the project. Because of an undercommitment of funds, Ford found itself short on production capacity, which caused lost and postponed sales of the automobile.

Finally, the amount of funds available for investment is limited. Thus, once a company makes a capital investment decision, alternative investment opportunities are normally lost. The benefits or returns lost by rejecting the best alternative investment are the opportunity cost of a given project.

For all these reasons, companies must be very careful in their analysis of capital projects. Capital expenditures do not occur as often as ordinary expenditures such as payroll or inventory purchases but involve substantial sums of money that are then committed for a long period. Therefore, the means by which companies evaluate capital expenditure decisions should be much more formal and detailed than would be necessary for ordinary purchase decisions.

Project selection: A general view

Making capital-budgeting decisions involves analyzing cash inflows and outflows. This section shows you how to calculate the benefits and costs used in capital-budgeting decisions. Because money has a time value, these benefits and costs are adjusted for time under the last two methods covered in the chapter.

Money received today is worth more than the same amount of money received at a future date, such as a year from now. This principle is known as the time value of money. Money has time value because of investment opportunities, not because of inflation. For example, $100 today is worth more than $100 to be received one year from today because the $100 received today, once invested, grows to some amount greater than $100 in one year. Future value and present value concepts are extremely important in assessing the desirability of long-term investments (capital budgeting).

The net cash inflow (as used in capital budgeting) is the net cash benefit expected from a project in a period. The net cash inflow is the difference between the periodic cash inflows and the periodic cash outflows for a proposed project.

Asset acquisition Assume, for example, that a company is considering the purchase of new equipment for $120,000. The equipment is expected (1) to have a useful life of 15 years and no salvage value, and (2) to produce cash inflows (revenue) of $75,000 per year and cash outflows (costs) of $50,000 per year. Ignoring depreciation and taxes, the annual net cash inflow is computed as follows:

Depreciation and taxes The computation of the net income usually includes the effects of depreciation and taxes. Although depreciation does not involve a cash outflow, it is deductible in arriving at federal taxable income. Therefore depreciation is subtracted to get net income but is not included in the cash flow since it does not involve cash.  Income tax expense is based on net income and not net cash flow.  To calculate income taxes, we use the following formula:

Income before taxes x tax rate = income tax expense

Keep in mind, you will use the income tax expense amount calculated under both the net income and net cash flow since income tax is a cash expense.

Using the data in the previous example and assuming straight-line depreciation of $8,000 per year and a 40% tax rate. Now, considering taxes and depreciation, we compute the annual net income and net cash inflow from the $120,000 of equipment as follows:

Notice how depreciation of $8,000 is NOT included in the net cash inflow because it is a non-cash expense.  Also note, the income taxes expense calculated under net income is the same amount reported under the net cash inflow since we have to pay income tax based on net income in cash.

Asset replacement Sometimes a company must decide whether or not it should replace existing plant assets. Such replacement decisions often occur when faster and more efficient machinery and equipment appear on the market.

The computation of the net cash inflow is more complex for a replacement decision than for an acquisition decision because cash inflows and outflows for two items (the asset being replaced and the new asset) must be considered. To illustrate, assume that a company operates two machines purchased four years ago at a cost of $18,000 each. The estimated useful life of each machine is 12 years (with no salvage value). Each machine will produce 40,000 units of product per year. The annual cash operating expenses (labor, repairs, etc.) for the two machines together total $14,000. After the old machines have been used for four years, a new machine becomes available. The new machine can be acquired for $28,000 and has an estimated useful life of eight years (with no salvage value). The new machine produces 60,000 units annually and entails annual cash operating expenses of $10,000. The $4,000 reduction in operating expenses ($14,000 for old machines – $10,000 for the new machine) is a $4,000 increase in net cash inflow (savings) before taxes.

The firm would pay $28,000 in the first year to acquire the new machine. In addition to this initial outlay, the annual net cash inflow from replacement is computed as follows:

Using these data, the following display shows how you can use this formula to find the net cash flow after taxes:

Remember, depreciation is a non-cash expense so it will not change net cash BUT it will change income tax expense as it is reported for net income.

Notice that these figures concentrated only on the differences in costs for each of the two alternatives. Two other items also are relevant to the decision. First, the purchase of the new machine creates a $28,000 cash outflow immediately after acquisition. Second, the two old machines can probably be sold, and the selling price or salvage value of the old machines creates a cash inflow in the period of disposal. Also, the previous example used straight-line depreciation.
Out-of-pocket and sunk costs A distinction between out-of-pocket costs and sunk costs needs to be made for capital budgeting decisions. An out-of-pocket cost is a cost requiring a future outlay of resources, usually cash. Out-of-pocket costs can be avoided or changed in amount. Future labor and repair costs are examples of out-of-pocket costs.

Sunk costs are costs already incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount. The price paid for a machine becomes a sunk cost the minute the purchase has been made (before that moment it was an out-of-pocket cost). The amount of that past outlay cannot be changed, regardless of whether the machine is scrapped or used. Thus, depreciation is a sunk cost because it represents a past cash outlay. Depletion and amortization of assets, such as ore deposits and patents, are also sunk costs.

A sunk cost is a past cost, while an out-of-pocket cost is a future cost. Only the out-of-pocket costs (the future cash outlays) are relevant to capital budgeting decisions. Sunk costs are not relevant, except for any effect they have on the cash outflow for taxes.

Initial cost and salvage value Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use are part of the initial cost of the asset. If an investment has a salvage value, that value is a cash inflow in the year of the asset’s disposal.

The cost of capital The cost of capital is important in project selection. Certainly, any acceptable proposal should offer a return that exceeds the cost of the funds used to finance it. Cost of capital, usually expressed as a rate, is the cost of all sources of capital (debt and equity) employed by a company. For convenience, most current liabilities, such as accounts payable and federal income taxes payable, are treated as being without cost. Every other item on the right (equity) side of the balance sheet has a cost. The subject of determining the cost of capital is a controversial topic in the literature of accounting and finance and is not discussed here. We give the assumed rates for the cost of capital in this book. Next, we describe several techniques for deciding whether to invest in capital projects.