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Explaining Acceptability in the Capital Budget Process

written by: •edited by: Jean Scheid•updated: 4/1/2011

Any enterprise will be faced by a large number of possible projects at any time and must adopt criteria for acceptability of a project. The enterprise must determine a standard by which to evaluate each project, or select a capital budgeting method to enable it to choose between competing proposals.

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    Why Capital Budgeting is Needed

    Budgeting Capital budgeting is the process by which companies plan for major investment decisions such as building a new plant, relocating production facilities to a low cost area, buying new equipment for the introduction of a new product line or entering a new market overseas. Generally there will be more potential projects available than can be undertaken at any time, and a method must be devised for selecting which projects can be taken forward and which potential projects must be rejected or at least postponed until economic conditions change.This will involve setting criteria for acceptability in a capital budget process.

    All capital projects will involve an initial outlay of funds and probably some delay before earnings are achieved from the project. The timing and amount of the capital outlays, and the time when earnings begin to flow in, will be different for each project. Some types of projects aim at making production more efficient and will be assessed on the basis of cost savings rather than increased sales. The criteria for evaluating different projects and selecting the most suitable must be able to compare these different scenarios in a meaningful way and arrive at an objective assessment of the feasibility of each project. The method used must be capable of assessing the viability of projects and drawing a line between those that will go ahead and those that will be rejected.

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    Capital Budgeting Decisions

    The types of capital budgeting decisions may be categorized into certain general categories. There are decisions in relation to efficiency and cost reduction, such as the purchase of more efficient equipment to streamline production and increase productivity. Some decisions are generally concerned with expanding the business, such as the purchase of new facilities aimed at increasing production or developing new product lines.

    Another type of decision is connected with choosing between a number of different types or make of equipment, based on the characteristics of the equipment and its suitability for the type of business the enterprise is engaged in. Another variant on this is the decision to replace existing equipment, which involves capital outlays, but improves efficiency. Here, by delaying the replacement and saving the capital outlay, the business could see less efficient equipment and possibly lower production levels.

    A further category of the capital budgeting decision is the lease or buy decision, which compares the regular payment for leasing a machine with the single initial outlay that might be made to purchase a new machine, perhaps financed by a loan, taking into account the tax considerations.

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    Criteria for Accepting an Investment Project

    Capital Equipment 

    In very broad terms, the process of accepting or rejecting capital projects can take the form of screening decisions or preference decisions. In the case of screening decisions, the acceptance or rejection of the capital project depends on a standard or benchmark for acceptance that has previously been determined as a matter of policy. This might be represented by a particular minimum rate of return on the capital outlay.

    A preference decision, on the other hand, is the result of comparing a number of different projects and is made on the basis that the chosen project is preferred to the alternatives rather than meeting any predetermined benchmark. An example might be the situation mentioned above of a decision to purchase one particular type and make of machine rather than the competing types and makes of that machine. The criteria for making the investment decision are, therefore, related to the available alternatives rather than any objective requirement.

    In considering the criteria for acceptability in a capital budget process, the screening decision or preference decision must be based on reasonable forecasts and assumptions about the outcome of each potential project in terms of the initial capital outlay required and the future cash inflows from the project. Based on these assumptions, the enterprise will then need to choose a method for evaluating each project and comparing it either to the required standard or to competing projects that could be undertaken.

    Please continue to Page 2 to learn about methods for evaluating investment projects and acceptance of the capital budget process.

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    When deciding on the criteria for acceptability in a capital budget process, the enterprise must use a technique for evaluating the return on the project. Two methods commonly used are to find either the internal rate of return of the project or the net present value of the cash flows. Another method sometimes used is the payback method although this may be used more as a rule of thumb than as a method to select a project.
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    Methods for Evaluating Investment Projects

    Although screening and preference decisions in capital budgeting differ in the way in which they set the criteria for acceptance of investment projects, they use the same techniques for evaluating the projects. One of the best known techniques is to find the internal rate of return of an investment. This is the rate of return on the investment over the life of the project. The internal rate of return is effectively the discount rate at which the cash inflows from the project would be the same as the cash outflows.

    For example, if there is a certain capital outlay at the beginning of the project, and a few years later there will be cash inflows that are much greater than the initial outflow of funds, a large discount rate would be required to equate these inflows to the initial outflow. The internal rate of return of that project is, therefore, high. The project would be selected by the enterprise provided that this internal rate of return is greater than the predetermined minimum rate of return (using the screening method) or is greater than the internal rate of return of competing projects (using the preference method). The minimum rate of return determined as a standard for acceptance of capital projects is likely to be based on the company's cost of capital.

    Vans, Light Truck and Trucks Assorted 0220 (5) Using the internal rate of return works reasonably well if the project consists of an initial outlay followed later by cash inflows. However, many projects involve irregular cash flows in both directions, such as an initial outlay followed by some further cash outflows at a later date, and cash inflows that may vary greatly from one year to another.

    To avoid some of the problems involved in using the internal rate of return, enterprises may often use another method of selecting capital investments which is to find the net present value of each project. This involves discounting the future cash inflows and outflows at a particular discount rate to arrive at the net present value of the project.

    The discount rate would be determined according to the enterprise's required rate of return on projects, which in turn would be based on the enterprise's cost of capital. Where the present value of the future inflows exceeds that of the outflows, so the net present value of the project is positive, this may indicate the enterprise should go ahead with the project, as it satisfies the minimum requirements built into the selection of the discount rate. Where a preference decision is required, the net present value of the proposed project will be compared to that of the competing projects to arrive at the capital budgeting decision.

    A further method that may be used is the payback method, which considers the amount of time required for the project to cover its original cost from subsequent cash inflows (the payback period). A maximum payback period could be selected as a standard for acceptance of projects. This method gives only a rough indication of the viability of a project as it does not directly assess the level of profitability of the project or the length of time over which the cash inflows will continue after the initial investment has been recovered.

    It also does not take into account the time value of money as no discount rate is used. The payback method is also less useful if there are uneven cash outflows and inflows over the course of the project.

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    Acceptance of Projects in the Capital Budgeting Process

    A general weakness of all the methods used for arriving at capital budgeting decisions is that they depend on estimates of future cash flows from the project, and also in the case of the net present value method an estimate of the appropriate discount rate. These cash flow forecasts and other assumptions may ultimately prove to be incorrect. Although the internal rate of return and the net present value methods in particular appear to strive for accuracy in evaluating projects, they can only be as accurate as the forecasts on which they are based. Whether acceptability is determined by a screening decision or a preference decision, making the right decision is dependent on the accuracy of the cash flow forecasts for each project. If these forecasts are inaccurate then the criteria for acceptability in a capital budget process cannot produce the correct decision.

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    References

    "Typical capital budgeting decisions" on Accounting for Management - retrieved at http://www.accountingformanagement.com/typical_capital_budgeting_decisions.htm

    "Capital budgeting" on netMBA - retrieved at http://www.netmba.com/finance/capital/budgeting/

    Image credits:

    Budget - cohdra on morguefile

    shovelmachine.jpg by taliesin on morguefile

    "Vans, Light Truck and Trucks Assorted 0220 (5)" by alvimann on morguefile