For the growing firms, Capital investments decisions are very important to stay in the business and to remain competitive in the market. The planning for capital investments is very complex and involves many persons inside and outside of the company, as these decisions cannot be reversed at a low cost and mistakes can be very costly. The nature and complexity of capital decision can vary depending on the size of the project. Lower-level managers may have a discretion to make decisions that involves less than a given amount of money or that do not exceed a given capital budget. Larger and more complex decisions are reserved for discretion of top management and some are so significant that a company’s board of directors ultimately has the decision-making authority.
Capital budgeting is a cost-benefit analysis. At the margin, the benefits from improved decision making should exceed the costs of the capital budgeting efforts in order to create wealth for shareholders.
The Capital budgeting decisions are based on cash flows rather than accounting net income which deduct the non cash charges and more importantly based on timing of cash flows where capital decision maker put extraordinary efforts in order to determine with precision when cash flows will occur. The Relevant cash flows in capital budgeting decisions depend on future cash flows and future benefits including non-cash expenses and income. To determine the relevant cash flows, high level of professional skills is mandatory for judging the relevant or irrelevant cash or noncash expenses. Relevant cash flows are of two types of outputs that are, cash and cash inflows. Cash outflows are relatively easy to determine, including initial capital costs plus the cost of installation of plant and machinery. You can also include the reversal of initial working capital repayment after project completion. Cash inflows are more technical in nature and are determined by adding depreciation to profits after tax for each year. Moreover, residual value of an asset and recovery of working capital is also added at the end of the project.
For cost-benefit analysis, we implied time value of money technique using the discount rate. The discount rate we used in capital budgeting could be different from the firm discount rate as it depends on riskiness of the project like replacement projects have probably the same risk as the firm but expansion projects are more riskier project where a new discount rate or required rate should be determined. The discount rate is a rate which is required on a project by a diversified investor.
The discount rate should thus be a risk adjusted discount rate. In order to calculate the discount rate for a particular project, there two equilibrium models, for estimating this risk premium, are the capital asset pricing model (CAPM) and arbitrage pricing theory (APT).
In the CAPM, total risk can be broken into two components: systematic risk and unsystematic risk. Systematic risk is the portion of risk that is related to the market and that cannot be diversified away. Unsystematic risk is non-market risk that can be diversified away. Diversified investors can demand a risk premium for taking systematic risk but not unsystematic risk. When corporation is diversified or investors who are financing the project are diversified investor, it would be inappropriate to incorporate unsystematic risk factor in determining the required return for the project.
The last important consideration in capital budgeting is forecasting the inflation to incorporate its effect in cash flows and discount rate. Accuracy of estimation in forecasting inflation is essential because if the inflation is higher than expected, the profitability of investments is correspondingly lower than expected. Inflation essentially shifts wealth from the taxpayer to the government. Higher than expected inflation, higher will be the corporation’s real taxes because it reduces the value of the depreciation tax shelter.