What is capital budgeting?
Capital budgeting is, “the process of establishing the amounts necessary to finance the activities of a business over a period of time, based on the expected return on investments in an economic cycle.” The theoretical basis for capital budgeting is provided by the neoclassical economic theory. It states that “there exists an optimal rate of investment and then that investment, net of taxes and depreciation, is equal to a level equal to total savings in the economy (this is equivalent to net investment).”
Fintalent’s Capital Budgeting Consultants define it as the process of projecting a company’s expected financial future and then deciding how much capital the company should maintain in order to maximize its value. The figure estimated by management which indicates how much capital the company needs to maintain is called the target capital structure.
Capital budgeting in M&A
In merger and acquisition (M&A), it serves as a basis for negotiations because different types of businesses use differing levels of debt. This can be due to differences in circumstances, such as one being more leveraged than another, or just personal tastes that are different from firm to firm. This can be a problem because it may cause a discrepancy between the expected future cash flows and the financing needed to obtain that cash.
When considering capital budgeting, there are two major elements: where to hold the company’s capital and what return on investment (ROI) will be needed. The process is also closely related to internal rate-of-return calculations for projects.
Capital is held in different financial instruments such as bonds, stocks and preferred stock. Managers must decide which ones are appropriate at any point in time, based on factors such as interest rates and expected capital payouts. The bonuses paid out over time to the executives of firms is another element of capital budgeting which influences how much equity they need to hold.
Capital budgeting for strategic decisions
Capital budgeting is also used by firms to make strategic decisions, such as whether to expand or buy other firms. The process can be used in mergers and acquisitions (M&A) for companies that both want to grow, but have different capital needs. It can also be used when a company wants to buy an already-existing company, otherwise known as a leveraged buyout (LBO).
In the simplest case in which each firm uses the same level of equity capital and debt, management can use their estimates of future revenue (or cash flows) relative to net fixed expenses (that is costs that do not vary with sales revenues) as a proxy for ROI. For example, if a firm has $50 million of net fixed expenses, revenues of $500 million and net profit of $200 million, then the ROI is 20% ($200/$50).
If the expected ROI for each firm is less than the target capital structure (TCS) for its industry, then it means that each company should adjust its capital structure by lowering debt or increasing equity capital. If management does this, it will increase the value of the firm because better-than-expected sales and profits will cause changes in asset prices which increase book value.
In this case, management must consider whether to issue stock or bonds to finance any additional capital expenditures. The amount of money that the company needs to raise is called the gross cash outflow. The expected ROI must be adjusted for the costs of financing. If the companies are merging, this adjustment can be based on their existing capital structures and interest rates.
The gross cash outflow is then compared with the gross cash inflow over time. This should be equal to the new firm’s excess cash flow after investment in order to have no change in value. However, management might have made mistakes in its estimations of future values or some other unexpected event may have occurred. This sets a range for how much return on investment (ROI) is acceptable for investors in each period (but future periods are generally more important than current ones). The bank will then lend the sum of cash inflow less cash outflow over time.
The entire process is calculated at the beginning of the period or before each period. The capital structure has to be adjusted if any assumptions change, such as changes in interest rates or projections for future sales. This is also true for earnings and cash flows for any new operations.
A capital budget should be created for long-term investment and should be based on the expected return on investment for that particular type of investment. Although capital budgeting can be performed for every type of investment, it does not apply to sales, purchasing, or financial expenditures. For example, a company would not budget for future sales in the year at hand but would make investments based on projected future sales. The difference between capital budgeting and cash flow is that the latter is more pertinent to short-term activities while the former is more relevant to long-term items such as purchases, investments, and depreciation. “The Capital Budgeting process is essentially two parts:
1) determining the amount of funds to be invested in each quarter over a period of time; and
2) deciding how to invest these funds.”
There are three basic decision points to be addressed by Capital Budgeting. They are
1) determining amounts to be invested in business activities;
2) Establishing investment policies with respect to different risk categories; and
3) Making decisions about borrowing.
Types of Capital Budgeting
a) Constant investment,
b) Periodic investment (seasonal),
c) Fixed (gearing),
d) Variable investment,
e) High-risk fixed,
f) High-risk variable,
g) Low-risk (hit and run),
h) Mixed asset and liability vehicles,
i) Mixed income and expense vehicles.
The most important element of capital budgeting is the calculation of the discount rate. The discount rate is used to determine the value of an investment based on the period in which it will be made. There are many ways to calculate the discount rate, but they all depend on three factors:
2) opportunity cost; and
Each method of calculating a discount rate has its own benefits and disadvantages. Different companies will use different methods to calculate the discount rate. It is always recommended that companies consider a variety of discount rate calculation methods before settling on just one for their budgeting purposes.
“Most capital budgets include a riskier element called “gearing” (or leverage) and are referred to as variable-rate budgets. The use of gearing involves borrowing money at a lower interest rate (say prime lending rates) with higher debt or equity ratios. A company may determine that it would be cheaper to make purchases with borrowed money than by going into debt.”