The Need for Capital Budgeting
The managers of an enterprise are responsible for increasing shareholder value and they need to evaluate projects on this basis. However, at any particular time, management will be faced with a number of potential capital projects and need to find some reliable criteria to assess the most suitable projects for the enterprise. This necessity to reliably evaluate projects and select the most suitable is the reason why various capital budget methods have been devised to assist management with their capital budgeting decisions.
The types of project that an enterprise might engage in may differ from each other in many important respects such as the size of the initial outlay of funds, the length of the project and the time at which earnings (or cost savings) will arise from the project. The benefits from a project may arise in different ways and for some projects the cash flow will be more predictable than for others.
Certain projects are concerned with achieving greater efficiency and reducing costs, so the benefits will not be seen directly through cash inflows but will be seen in reduced cash outflows in the future. The purchase of more efficient machinery or software would come into this category. Another capital budgeting decision might involve a major expansion of the business, such as opening a new factory or opening up a distribution operation in a new market. Other capital budgeting decisions are concerned with the replacement and updating of equipment. Examples of this type of decision are the selection of a new model of a machine to purchase, the decision to lease or buy equipment or the decision to postpone the replacement of certain plant.
The needs and preferences of different enterprises and different shareholders in an enterprise may also differ and this could complicate the capital budgeting decision. Management must determine if the best type of project for the enterprise to engage in is one which increases the long term value of the enterprise, or one which increases earnings in the short term. Although a number of different methods exist for evaluating projects, the ultimate choice of which projects to pursue is a matter of judgment for the management rather than an inevitable consequence of applying the capital budgeting methods. The application of certain popular capital budget methods does, however, increase the information available to management and enable them to arrive at a decision.
Many projects will be accepted by management if they exceed a certain predetermined minimum rate of return, that may be based on the enterprise's cost of capital. These are referred to as screening decisions because projects are matched against a certain standard and are accepted if they meet that standard. Other capital budgeting decisions, for example the replacement of equipment, may involve the selection of one course of action from a number of possible alternatives. These are referred to as preference decisions because the alternatives are compared and the preferred project is selected. Various capital budget methods are used by management to evaluate and select projects.
Please continue to Page 2 for more on capital budgeting methods.