Capital budgeting is the procedure for establishing whether or not a company should invest in projects such as new facilities or products. This article presents the most common methods of capital budgeting; discusses economic issues in capital budgeting unique to three types of companies: Steel producers, small companies, and U.S. multinational subsidiaries; and provides a glossary of relevant terms.
Keywords Capital Budgeting; Cash Flow; Discounted Cash Flow (DCF); Internal Rate of Return (IRR); Manufacture; Net Present Value (NPV); Payback Period; Present Value (PV)
Manufacturing: Capital Budgeting
When a company plans to invest in new facilities, equipment, or products, it may engage in capital budgeting. Capital budgeting is a strategy that a company can utilize to plan future investment projects.
A company utilizes capital budgeting to establish whether a project’s benefits will outweigh the costs of investing in the project. The process generally involves constructing a formula that considers total funds needed for the project, including working capital; the financial benefits expected from the project; the length of time needed to reap the financial benefits of the project; and whether it is better to forego the project completely. For example, a company that manufactures furniture is considering whether or not to also start manufacturing its own fabric for the furniture. The furniture manufacturer can use capital budgeting to determine the most financially profitable option for manufacturing fabric among the following four investment projects:
- Remodel a current facility to accommodate a fabric manufacturing operation.
- Build a new fabric manufacturing facility.
- Purchase an existing fabric manufacturing company.
- Continue to purchase the fabric rather than manufacture it. (If this option is chosen, the project is then removed from consideration as a capital budgeting project.)
As part of the capital budgeting process, companies consider their access to funds; their need for cash flow to operate the company throughout the timeline for any capital budgeting project; and in some instances, their responsibility to shareholders.
Capital Budgeting Valuation Methods
A variety of approaches and mathematical formulas may be used in capital budgeting. Four of the most common approaches used in capital budgeting are based on the following four valuation methods:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Discounted Cash Flow (DCF)
- Payback Period
Net Present Value (NPV)
The first capital budgeting valuation method is net present value (NPV). NPV reflects the variance between the current amount of cash inflows and the current amount of cash outflows. Present value refers to the current worth of money that will be received in the future, based on a particular rate of return.
Internal Rate of Return (IRR)
The second capital budgeting valuation method is internal rate of return (IRR). IRR, which is sometimes called economic rate of return, refers to the discount rate that renders the NPV of all cash flows for a specific project equal to zero. Usually, the higher the IRR for a specific project, the more financially attractive the project will be.
Discounted Cash Flow (DCF)
The third capital budgeting valuation method is discounted cash flow (DCF). In DCF, future free cash flows are discounted to arrive at a present value. For a project to be considered worthwhile according to this valuation method, the DCF must be greater than the present investment cost.
The last capital budgeting valuation method is payback period. The payback period refers to the amount of time needed to recapture the cost of an investment. In general, the sooner a company can recover the cost of their investment, the more financially attractive the project will be.
The payback method of valuation does not measure the time value of money or reflect any financial benefits that would occur after the payback period. Therefore, this method of capital budgeting is considered less effective than the NPV, IRR, or DCF methods.
Economic Issues in Capital Budgeting Decisions
In addition to considering their corporate financial goals, companies need to also consider how national and international economic issues will affect their capital budgeting decisions.
This section explores three topics that consider the economic issues that affect capital budgeting:
- A capital budgeting issue for U.S. steel producers.
- The capital budgeting decisions of small companies.
- The results of an analysis of capital budgeting strategies of U.S. multinational subsidiaries.
A Capital Budgeting Issue for U.S. Steel Producers
The first economic issue in capital budgeting covers a capital budgeting issue for U.S. steel producers.
Should U.S. steel producers expand their capacity in order to avoid being the lowest-cost suppliers to the U.S. market? At least one industry analyst says "No." Michelle Applebaum, an independent steel industry analyst, discusses why she disagrees with those who think that U.S. steel producers need to expand their capacity (production) in order to prosper in the marketplace.
Applebaum offers three reasons why expanding capacity isn't desirable:
- Limited resources, such as scrap metal, are available.
- The delivery of steelmaking equipment requires an exceptionally long lead time.
- The potential for a surge in exports from China remains an economic threat.
She reasons that any capital budgeting that includes a new capacity project would have to assume a period of negative returns in order to yield a net positive return (Applebaum, 2007, p. 91).
Instead of investing in capital budgeting projects to increase production capacity, Applebaum suggest that it would be more mutually beneficial for steel producers and their customers to engage in the following practices:
- Steel producers: Allow for flexible arrangements with customers. Reduce volume when business conditions warrant this practice, rather than forcing...