1.4 Capital Budgeting: The Investment Decision
The phrase “Capital Budgeting” begs explanation. This phrase obviously consists of two terms. Let’s take “budgeting” first. Budgeting refers to the process whereby limited financial resources are allocated to alternative investment choices. If an individual has only $25,000 to spend on an automobile due to the limits of her budget, that Ferrari is not going to happen.
You’re right. I did lose a million dollars last year. I expect to lose a million dollars this year. I expect to lose a million dollars next year. You know, Mr. Thatcher, at the rate of a million dollars a year, I’ll have to close this place in… 60 years.
– Orson Welles, Citizen Kane.
If your funds are unlimited, why budget? No one has unlimited funds (except Citizen Kane!). Thus, one must decide what is the best choice of investment with only limited funds. Budgets can be applied to spending on short-term resources, such as food in an individual’s case, or on inventory or wages in the case of a corporation. In any event, such “operating” expenditures are consumed during the accounting period, and may be regulated by the annual “operating budget” established corporately.
Corporations occasionally spend money on “capital” assets, i.e., long-term needs as well. These investments (the word “investment” itself connotes long-term) are not consumed during the accounting period, but over many future periods. Indeed, the External Funds Needed (“EFN”) formula projects the amount the corporation will need in order to acquire additional assets to fund growth. The process by which capital resources are allocated to long-term investments is referred to as “Capital Budgeting” (CB). The corporation must make optimal investment decisions given its limited capital resources. “Optimal” investment decisions are those which maximize return (given an acceptable risk level), profits, and firm wealth.
On the following pages we will examine numerous mathematical and analytic techniques for capital budgeting. We shall assume that an analyst, ex-ante, has provided pro-forma accounting income, (free-) cash flow, or similar data, which shall then be subjected to Capital Budgeting analysis. We shall further (unrealistically) assume that the forward-looking data are 100% certain as to their actual future occurrence. Finally, we will not evaluate qualitative considerations, which may alert the analyst, in practice, to recommend some other strategy or alternative, even when the numbers may “speak” otherwise. In reality, the analyst will have to “know the business” in order to engage in such departures.
Investment-, or capital-projects, may be categorized as either “independent” or as “mutually exclusive.” This categorization will impact the capital budgeting decision, as discussed below.