8.1. Meaning of Capital Budgeting
Capital Budgeting refers to the process of evaluating potential projects for future investments. Projects such as construction of offices, purchase of equipment or acquisition of another company are alternative projects; but each project has different costs and returns. Capital budgeting allows the company to analyze the costs and expected returns of each project in order to choose the best option. A company can evaluate the lifetime cash inflows and cash outflows of each project against a set benchmark. Capital budgeting is also known as investment appraisal, and it helps in making investment decisions as we have noted in chapter 7.
The aim of capital budgeting is to identify and pursue opportunities that provide the highest profit and greatest shareholder value. This process makes sense because companies face the challenge of scarcity of resources. Capital budgeting processes enable the company to determine the projects that will require the least resources and produce the highest possible returns.
In chapter 7, we have seen numerous capital budgeting techniques that can be used to assess the viability of investment projects. We have seen that capital budgeting methods can be classified into two broad categories: Discounted and non-discounted cash flow analysis.
Discounted cash flow methods include:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Profitability Index (PI)
Non-discounted cash flow methods are:
- Payback Period (PBP)
- Accounting Rate of Return (ARR)
Discounted cash flow methods consider the time value of money. It considers the initial cash flow used to fund the project, plus the mix of cash inflows in form of revenue and other cash outflows that may be incurred in form of maintenance, depreciation, and other costs. The present value of an investment is the discounted cash inflow minus the discounted cash outflow of future investments. For example, the revenue from a project in the second year is discounted using an applicable discount rate to get its present value. The concept of present value suggests that the amount of money earned today is worth more than the same amount in future.
Any investment project involves an opportunity cost, which means that the company or individual forgoes something else to invest in a particular project. For instance, if you decide to buy land, you forgo the return of depositing the money in an interest-earning bank account. The amount you earn from purchasing land should exceed the amount you could have earned if you deposited the money in a bank. In other words, the cash inflows or revenue from the project needs to be enough to account for the costs, both initial and ongoing, but also needs to exceed any opportunity costs
Non-discounted cash flow analysis includes payback period, which allows a company to analyze the number of years that a project takes to return the initial investment. The payback period method is usually used by companies that have limited financial resources so that they can know how quickly they will recoup their investment capital. On the other hand, the accounting rate of return looks at the accounting profits that project will earn compared to the investment’s costs.
8.2. Capital Budgeting Process
Since we have seen various capital budgeting techniques in the previous section, we shall consider the capital budgeting process for this chapter.
The amount of money that a company has in its investment account are not always enough to pursue all or many projects. Yet there are always several investment options and opportunities to choose from. The firm can decide to buy or lease an equipment instead of acquiring a marketing firm. Deciding to choose one opportunity instead of another is should be based on an objective analysis. The capital budgeting process is a series of steps that a company follows to choose investment projects and allocate scarce capital to the most valuable investments. There are various approaches that a firm can use to identify viable projects, but the most common steps involved in the capital budgeting process are described as follows
Step 1: Identify Investment Opportunities or Projects
The first step in the capital budgeting process is to explore available investment options. A company may consider up to five projects that are consistent with their business model and organizational objectives. To identify viable opportunities, the company should conduct analysis of their external and internal business environment. This allows them to determine the best strategies and assess their ability to meet the needs of each project. For instance, external environment analysis may involve the evaluation of technological factors and trends. This could lead to the identification of an opportunity to acquire a new technology or software. But the analysis should not end there. The company should continue exploring other investment options.
Step 2: Evaluating Projects
After identifying more than one investment opportunities, the company uses various investment appraisal techniques and criteria to evaluate each project. When evaluating investment options, the company should choose the most appropriate capital budgeting technique to ensure that they get the best results. The assessment of alternative projects should also consider the company’s mission and vision. This step of the capital budgeting process involves assessing the costs and risks of each investment option. The manager should evaluate the total cash inflows and cash outflows to determine whether the project is viable.
Step 3: Selecting the Best Option
In the third step of the budgeting process, the company chooses the project that has the best returns and little costs or risks. Every business has diverse requirements and therefore, the approval over a project comes based on the objectives of the organization. Before approving a project, the company’s management must assess the costs and returns of each option based on the most accurate criteria, considering the discount rates, risks, and future projected returns. The most viable, profitable, and sustainable project is chosen based on the results of the analysis done in step 2. This must get approval from the top management and sponsors before we proceed to the fourth step of the budgeting process.
Step 4: Implementation of the Project
The investment project that has been chosen based on objective analysis is implemented. Implementation of a project involves allocating financial resources, human resources, and assets to the project. The process also entails developing a plan that identifies specific courses of action and putting the project’s activities into action. For instance, if the project is to deploying a new software, the company may create a project team that will manage the implementation of the new software. The actions may include allocating money, hiring IT experts, and purchasing the new software, training employees to use it, and deploying it across the organization.
Step 5: Evaluation and Monitoring
Once the project has been implemented, the management team will review its performance to ensure that it meets the intended results. Evaluation involves the process of analyzing and assessing the actual results over the estimated outcomes. The company should monitor results to identify flaws and eliminate for future project proposals. Evaluation also enables the firm to track performance and ensure that the project has achieved the intended outcomes. If not, corrective action is taken to minimize losses and increase returns.
8.3. Capital Rationing
Capital rationing refers to an approach used to limit the number of projects that a company or an investor should take on at any particular time. Usually there are numerous alternative investments that a company can implement to generate income; but the company cannot invest in all of them due to the scarcity of resources. Capital rationing helps the business to choose the most profitable investments and allocate the required amount of capital. Capital rationing is important for any company because it helps the company to put their money in the most profitable projects. A company that uses capital rationing will earn a higher return on investment (ROI) because it is able to invest their resources in areas that have the potential of generating the highest profits or returns.
In general, capital rationing is concerned with putting restrictions on investment projects that a business can take on at a time.
How to calculate capital rationing
To calculate capital rationing, you apply the following formula for each project:
Profitability = NPV/Investment Capital
The next step is to rank projects based on the profitability calculated using the formula above.
A company has five possible projects to invest, but it can choose only 2 projects. The NPVs and Investment Capital for the five projects are listed below:
|Project||Investment Capital ($)||NPV ($)|
|1||2 billion||2 billion|
|2||4 billion||2 billion|
|3||5 billion||3 billion|
|4||4 billion||4 billion|
|5||6 billion||5 billion|
Required: Determine which two projects should the company choose?
Calculate the profitability of each project using the formula:
Profitability = NPV/Investment Capital
|1||2 billion / 2 billion||1|
|2||2 billion / 4 billion||0.5|
|3||3 billion / 5 billion||0.6|
|4||4 billion / 4 billion||1|
|5||5 billion / 6 billion||0.83|
Based on the table above, the projects can be ranked as follows: 1 = 4 > 5 >3 > 2. In this regard, the company should choose project 1 and project 4 because they have the highest profitability.
Types of Capital Rationing
There are basically two types of capital rationing: hard and soft capital rationing.
Hard Capital Rationing
Hard capital rationing is a type of rationing that is imposed to a company by factors beyond their control. For example, poor credit rating may prevent a company from borrowing funds to invest in new projects. If a company faces restrictions on access to credit for any reason, it may not be able to finance many projects. It has to limit its investments to the amount of money it has in its capital reserves or retained earnings. Another reason for hard capital rationing is when prices of inputs have risen suddenly due to unexpected inflation in the economy, which makes it difficult for the company to raise enough money to buy inputs.
Soft Capital Rationing
Soft capital rationing is a situation whereby a company chooses freely to limit its investments even if it has enough capital to do as many projects as possible. For instance, a company may decide to pursue only those projects that have a high rate of return. The company may also reduce its investment appetite to avoid taking too many risks and take a cautious approach to minimize risks.
Advantages and Disadvantages of Capital Rationing
Capital rationing is important for any business because it ensures that the firm chooses only the most feasible investments. It allows the company to invest only on those projects that have potentially high returns. However, even when there are promises of high returns an investor may want to prefer current cash flows over investments.
- Limited Number of Projects are Easier to Manage
Companies can use capital rationing to limit the number of projects to invest in order to make it easier to manage the chosen projects. A large number of projects may be difficult to manage simultaneously. Sharing funds and human resources among multiple projects cause a strain on the company’s resources and finances.
- Increased Flexibility
Capital rationing gives the company the flexibility it needs to adjust to changing circumstances in the business environment. By limiting the amount of cash used in funding investment projects, the company ensures that it has enough cash flows to achieve stability and meet emerging financial obligations. Keeping a reserve of cash also enables the firm to take advantage of lucrative opportunities whenever they emerge.
- High Capital Requirements
A company that has little funds does not have the luxury to do capital rationing. Capital rationing may sometimes require a large amount of capital to invest in the most lucrative investments.
- Goes against the efficient capital markets theory
Capital rationing allows companies to select a few projects with potentially high returns instead of investing in all projects that offer good returns. However, the efficient capital market theory suggests that it is virtually impossible to continually select superior projects that significantly outperform others. It also exposes the company to higher risks because it does not allow them to hold a diversified investment portfolio.
8.4. Classifying Investment Projects
When classifying projects for potential investments, managers consider several factors such as:
- The amount of investment capital required, e.g. large, conservative, or small
- Type of income required, e.g. cost savings, expansion income, sales revenue, social effects, etc.
- Type of cash flow, e.g. ordinary or extraordinary
- Relationship type, e.g. independent project, complementary projects, or substitute projects.
- Attitude to risk – whether one is risk-averse or risk-tolerant.
Companies can invest in different types of projects based on the above factors. Some of the capital budgeting projects that a company can choose include:
- Expansion projects: these projects include those that involve the development of new products or selling existing products in new markets. These are projects that are important for the growth and expansion of a company, and it involves large capital investments.
- Acquisition of New Assets: a company may invest in a new asset such as equipment, land or new facility. The company can buy land and construct its manufacturing plant, or buy a machine to process food or print papers.
- Replacement/Repair of Existing Assets: Existing equipment, land or motor vehicles may need substantial repairs or maintenance; which may need a significant amount of capital to invest. The company may also need to replace a worn-out equipment or machine.
Projects can also be classified by:
- Project Size: small projects may be implemented within departments while large projects are managed by the executives.
- Benefit to the firm: some projects are implemented to increase cash flows, others are aimed at reducing costs, and others reduce risks.
- Degree of Dependence: independent projects v mutually exclusive projects; complementary v substitute projects.
- Types of Cash Flows: Conventional v non-conventional cash flows.
8.5. Investment Valuation
Investment valuation refers to the process of determining the fair value of an asset or a company using quantitative calculations. There are several ways of determining the worth of a project; and each valuation method is affected by the company’s financial performance and economic events in the external environment. Investment valuation can also be described as the analytical process of establishing the actual and projected worth of an asset or company. When valuing a company, the valuer examines the firm’s shares, market value, cash flows, future earnings, etc.
There are two major classifications of investment valuation models are:
- Relative Model: in this model, an investment’s worth is measured in comparison with other investment projects based on their market prices.
- The Absolute Model: This model requires the company to find the fair value of an asset based on their projected returns or cash flows without comparing with other projects.
Investment valuation models are also divided into three major models:
- Dividend Discount Model (DDM): the dividend discount model is one of the absolute models of investment valuation. It is used to evaluate the value of an investment using dividends paid to shareholders. Based on this model, a company is valuable if it provides consistent stock dividends for shareholders, meaning that the firm is profitable and capable of creating stakeholder value.
- Discount Cash Flow Method (DCF): The cash flow dividend method is appropriate when a company does not pay dividends consistently. Shareholders will evaluate their investments in the company based on their discounted future cash flows. Based on this model, a viable project is the one that provides consistent, positive and predictable cash flows.
- Comparable Method (CM): The comparable method is a relative valuation method that compares the company’s price with industry benchmarks. In this case, the share price of a company is compared to the industry average to determine its performance when compared to other companies in the industry.
- Asset-Based Valuation: The asset-based valuation of a firm involves the valuation of a company’s assets to determine the fair market value of the firm’s total assets, less liabilities. This investment valuation of a company evaluates the assets of the company to determine its fair market value.
8.6 Risk and Capital Budgeting
Investment appraisal or capital budgeting involves the evaluation of investment options during financial planning to determine the viability of each option. Capital budgeting and investment decisions are often associated with significant risks. When choosing a project or to invest in, the company must consider all costs and risks involved with each choice. Risk can be defined as the possibility of an undesired outcome. In relation to investment, a risk is the possibility that the investment activity may lead to a loss or an undesired outcome. Some of the risks associated with investment projects together with the measures used to mitigate them are described below:
- Operational Risks: This type of risks includes all the internal and/or external conditions that affect the daily operations of business. Some of the operational risks that a business may encounter include natural disasters, bad weather conditions, damage to premises and equipment, delays in materials, and errors in payments. These risks can be mitigated by developing business continuity plans or contingency plans, which provide steps to be taken to minimize disruptions or reduce their impacts on business operations.
- Financial Risks: Also known as economic risks, this type of economic risks refer to the likelihood that an event may occur, leading to financial losses or reduced profits. Financial risks may be caused by fluctuations in exchange rates, price fluctuations, and market movements. Financial or economic risks can be mitigated by easing cash flows using appropriate cash management systems. Some organizations and individuals may also use insurance, diversifications, and reduced loans to mitigate financial risks.
- Security Risks: Some risks are related to security issues such as data breach, privacy violations, identify theft, fraud, money laundering, and intellectual property theft. These types of risks pose security problems to individuals and organization. Lack of security features in an online payment system may expose users’ data, which can be used to defraud unsuspected customers.
- Compliance/Legal Risks: the legal environment is constantly evolving as new laws and regulations are formulated to government business operations and contracts. A company should understand the legal frameworks under which their businesses operate to avoid litigation and legal liabilities. To mitigate compliance risks, the company should have a legal team that constantly assesses the legal environment to identify new laws and develop policies that are necessary to meet those laws.
- Reputational Risks: These risks include situations that can damage the company’s reputation or public image. For example, faulty products, poor customer support and negative publicity may lead to bad reputation for a business. To mitigate reputational risks, a company should develop a public relations team that communicates with the public to influence public opinion about the company positively.
8.7. Meaning of Financial Forecasting
Raising capital is not an instant thing. The firm has to plan in advance how finances would be raised. It is therefore important that the firm know the amount of capital that the firm know the amount of capital that it requires for planning purposes. Financial forecasting can be defined as the process of estimating the future financial performance of a company. This approach uses the past and present financial records to make predictions of future financial performance.
Financial forecasting is an important tool for promoting financial planning since it enables decision makers to allocate resources efficiently. Analysists create financial forecasts using various quantitative and qualitative techniques, such as regression, straight line methods, etc. Financial forecasting techniques provide predictions about the likely future performance of the company, while financial planning puts those forecasts into use in decision making and creating practical business strategies. Companies can use their financial statements to predict their likely future performance. Income statements provide valuable information that can determine the future outlook of the company.
Components of Financial Forecasting
Financial forecasting consists of various elements or components:
- Profit and Loss Statement: also known as the income statement, this item provides information about the company’s profitability. It lists the income and expenses of the company, as well as the firm’s profits and losses. The items that can be forecasted from an income statement included operating expenses, financial expenses, and revenue.
- Cash Flow Statement: The cash flow statement can be used to assess the amount of money that has been used or earned within a specific period. A cash flow statement can be used to estimate future cash flows and make future investment plans. A cash flow statement consists of several items that can be forecasted, including cash from operating activities or cash from financing activities.
- Balance Sheet: Some items in the balance sheet can also be forecasted to determine the future financial position of the company. a balance sheet consists of several items such as cash on hand, inventory, short term and long term assets, accounts receivable, accounts payable, and other liabilities. A company may use items in the balance sheet to predict future liabilities, long term debt, and retained earnings.
- Working Capital: future financial performance of a company can be predicted by analyzing the current working capital of the company. Working capital of the company can be used to predict future expenses such as dividends and taxes.
Calculating Financial Forecasting Using the Percentage of Sales Method
This is the most important method of financial forecasting and it involves the following steps;-
- Identify the balance sheet items which will change with the changes in sales. These items will include;
- Current assets and current liabilities: This will change with changes in sales unless there is a written contract.
- Fixed assets: This will only change with changes in sales of currency they are fully utilized i.e. operating at full capacity.
- Retained profits: This will change with changes in sales under the following two conditions;
- That the company is operating profitably
- That the company does not distribute all it’s earning as dividends.
- Long-term debt and equity: This will not change with changes in sales because the capital is incurred for capital expenditure and not for revenue expenditure.
- Express the various Balance Sheet items which changes with sales as a percentage of sales e.g. if the stock level in 2008 was Ksh.10M and the sales level during the period was Kshs.100M then stock as a percentage of sales will be: (Stock x 100)/Sales.
- Calculate the total financial requirement during forecasting period due to the increase in sales e.g. if the level of sales increased from Kshs.100m in 2008 to Kshs.120m in 2009 then the increase in stock can be determined as what?
- New level of stock = 10% of 120 = 12
Less original level = 10% of 100 = 10
- Increase in stock = % of stock x increase in sales
= 10% (120m – 100m)
- Determine the external financial requirements during the forecasting period using the following formula:
Increase in FA(if any) xxx
Add increase in CA/specify xxx
Add repayment of any liabilities xxx
Total financial requirements xxx
Less increase in CL/specify (xxx)
Less increase in retained profits (xxx)
External financial/borrowing xxx
8.8. Importance of Financial Forecasting
Financial forecasting plays a significant role in the financial planning and investment decisions of a company. By preparing financial forecasts, analysts are able to evaluate current and future financial needs of the company. It enables an organization to estimate future financial requirements based on information derived from the company’s financial statements. This helps the company to predict future financial trends and make proper plans and policies to achieve the organization’s financial goals. The advantages of financial forecasting include:
- Aligning business strategy: financial forecasting helps an organization to examine economic factors that may affect their business strategy. Estimating the future financial position of the firm is necessary to align the company’s financial plans with the organization’s strategy.
- Managing expenses effectively: financial forecasts allows an organization to make informed decisions about their daily business operations and control cash more efficiently, leading to cost minimization and increased profit margins.
- Compliance with the Law: An organization can use financial forecasts to prepare for possible insolvency issues and plan effectively to avoid bankruptcy. Understanding the future financial position of a company is necessary to meet regulatory requirements such as bankruptcy laws and SEC filing requirements.
- Proactive Decisions: financial forecasting is necessary to prepare a company for future financial uncertainties. It is a proactive way of developing business strategies and planning the future finances of the company.
- Improved Communication: Financial forecasting creates the right conditions for effective communication throughout the organization. A company can use financial forecasts to indicate the goals of the organization and allow everyone to work towards those goals. This enhance clear lines of communication are established to achieve the organizational goals.