Capital Budgeting Definition
Capital budgeting refers to the process in which a business ascertains and evaluates possible large investments or expenses. These investments and expenditures comprise projects like investing in a long-term venture or building a new plant. Most times, a company evaluates the lifetime cash inflows and outflows of a prospective project to ascertain if the potential returns gotten meet the desired target benchmark, also referred to as “investment appraisal.”
A Little More on What is Capital Budgeting
Typically, businesses should pursue every project and opportunity which improves shareholder value. However, because there is a limitation to the amount of capital available for new projects, management needs to utilize capital budgeting strategies in determining which projects would yield the highest return obedience an applicable timeframe. Various capital budgeting methods exist including net present value, discounted cash flow, payback period, throughput analysis, and internal rate of return.
Three popular methods exist for deciding the projects that should get investment funds over other projects. The methods include throughput analysis, payback period analysis, and DCF analysis.
Capital Budgeting with Throughput Analysis
Throughput is measured as the amount of material passing through a system. Throughput analysis is the most complex capital budgeting analysis type, but is also the most precise in assisting managers decide which projects to embark on. Under this method, the whole company is a single system which generates profit. The analysis assumes that almost every cost in the system is operating expenses, that in order for the company to pay for expenses it has to maximize the entire system’s throughput, and that maximizing profits involves maximizing the throughput passing through a bottleneck operation.
A bottleneck is the system’s resource which needs the longest time in operations. This implies that managers should give more preference to capital budgeting projects which affect and increase throughput passing through the bottleneck.
Capital Budgeting Using DCF Analysis
DCF analysis is synonymous to or the same as NPV analysis in that it examines the first cash outflow required to fund a project, the combination of cash inflows assuming revenue forms, and other future outflows assuming maintenance and other cost forms. These costs, save for the first outflow, are discounted back to the current date. The NPV is the resulting number of the DCF analysis. Projects having the highest NPV should rank over other projects except in situations where one or more are mutually exclusive.
The Most Simple Form of Capital Budgeting
Payback analysis is the easiest form of capital budgeting analysis, thus making it the least accurate.
However, managers still utilize this method because of its speed and its ability to give managers a quick understanding of the effectiveness of a project or group of projects. This analysis estimates how long it would take to recoup a project’s investment. One can know the payback period by dividing the initial investment by the average yearly cash inflow.
Reference for ”Capital Budgeting”
Academic Research on “Capital budgeting”
Rational capital budgeting in an irrational world, Stein, J. C. (1996). Rational capital budgeting in an irrational world (No. w5496). National bureau of economic research. This paper addresses the following basic capital budgeting question: Suppose that cross-sectional differences in stock returns can be predicted based on variables other than beta (e.g., book-to- market), and that this predictability reflects market irrationality rather than compensation for fundamental risk. In this setting, how should companies determine hurdle rates? I show how factors such as managerial time horizons and financial constraints affect the optimal hurdle rate. Under some circumstances, beta can be useful as a capital budgeting tool, even if it is of no use in predicting stock returns.
Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approachFroot, K. A., & Stein, J. C. (1998). Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach. Journal of financial economics, 47(1), 55-82. We develop a framework for analyzing the capital allocation and capital structure decisions facing financial institutions. Our model incorporates two key features: (i) value-maximizing banks have a well-founded concern with risk management; and (ii) not all the risks they face can be frictionlessly hedged in the capital market. This approach allows us to show how bank-level risk management considerations should factor into the pricing of those risks that cannot be easily hedged. We examine several applications, including: the evaluation of proprietary trading operations, and the pricing of unhedgeable derivatives positions. We also compare our approach to the RAROC methodology that has been adopted by a number of banks.
Value‐enhancing capital budgeting and firm‐specific stock return variationDurnev, A., Morck, R., & Yeung, B. (2004). Value‐enhancing capital budgeting and firm‐specific stock return variation. The Journal of Finance, 59(1), 65-105. We document a robust cross‐sectional positive association across industries between a measure of the economic efficiency of corporate investment and the magnitude of firm‐specific variation in stock returns. This finding is interesting for two reasons, neither of which is a priori obvious. First, it adds further support to the view that firm‐specific return variation gauges the extent to which information about the firm is quickly and accurately reflected in share prices. Second, it can be interpreted as evidence that more informative stock prices facilitate more efficient corporate investment.
Capital rationing and organizational slack in capital budgetingAntle, R., & Eppen, G. D. (1985). Capital rationing and organizational slack in capital budgeting. Management science, 31(2), 163-174. This paper reconciles three stylized facts about capital budgeting in firms and shows that they are tied to the presence of asymmetric information among the several members of the firm, each with his or her own objectives and decisions. The facts of interest are: 1. The existence of organizational slack. 2. The “rationing” of resources within organizations. 3. The stated “cut off rate” for accepting capital projects in firms is often greater than the market rate of interest. Organizational slack is defined as the excess of resources allocated over the minimum necessary to accomplish the tasks assigned. Resource rationing is defined as the under-allocation of resources; i.e., an increase in the amount allocated would generate revenues in excess of its costs. Rationing and slack are both manifestations of ex post inefficiencies. An LP model is used to show that these inefficiencies can occur in ex ante efficient organizational designs when asymmetric information is present. The optimal allocation policy involves a hurdle rate criterion in which the hurdle rate is strictly in excess of the cost of capital, thus inducing rationing in some states of the world. Typically, resources are optimally allocated such that slack exists in other states. The optimal allocation policy trades off these two inefficiencies.
How do CFOs make capital budgeting and capital structure decisions? Graham, J., & Harvey, C. (2002). How do CFOs make capital budgeting and capital structure decisions?. Journal of applied corporate finance, 15(1), 8-23. This paper summarizes the findings of the authors’ recent survey of 392 CFOs about the current practice of corporate finance, with main focus on the areas of capital budgeting and capital structure. The findings of the survey are predictable in some respects but surprising in others. For example, although the discounted cash flow method taught in our business schools is much more widely used as a project evaluation method than it was ten or 20 years ago, the popularity of the payback method continues despite shortcomings that have been pointed out for years. In setting capital structure policy, CFOs appear to place less emphasis on formal leverage targets that reflect the trade‐off between the costs and benefits of debt than on “informal” criteria such as credit ratings and financial flexibility. And despite the efforts of academics to demonstrate that EPS dilution per se should be irrelevant to stock valuation, avoiding dilution of EPS was the most cited reason for companies reluctance to issue equity.