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Capital Budgeting Summary
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Detailed and well summarised study notes of the capital budgeting section taught in financial management at UCT (FTX2024S).
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CAPITAL BUDGETINGWHAT IS CAPITAL BUDGETING?
- the analysis and evaluation of investment projects that normally produce future
economic benefits over a number of years to increase the value of the firm
- must consider entire project’s life before deciding to go ahead with project or not
- financial cash outlay will be upfront
- benefits (future cash flows) received over a number of years
Capital investment decisions
- decision to invest in a project (initial cash outflow) resulting in long term future cash
inflows and outflows
- investment decision is taken 1st
- then the financing (leasing, borrowing, and purchasing) decision
Why is the capital budgeting decision NB for the firm?
The SOFP:
- SOFP includes past capital budgeting decisions (Relevance and Feedback Value)
- tactical & strategic Investments → future wealth creation for shareholders
Consequences of investment & non-investment:
- analyse the SCF to evaluate investment intention, to increase the # of the firm
Investment risks:
- over capacity → high overheads – inefficiencies – lower profits
Non-investment risks:
- under capacity resulting in loss of market shar (lower profits)
- higher operating costs → sweating assets more frequent breakdowns
- loss of investment flexibility → large investment results in company losing option to
invest elsewhere
- focus should be on project and wealth creation in the future
CAPITAL BUDGETING PROCESS
1. Strategic plan
2. Proposal generation
3. Review and analysis
4. Decision making
, 5. Implementation
- after project has been approved the cash expenditures are made
6. Follow up (post project audit)
- annual results are monitored & the actual annual CFs are compared to the estimated
CFs
TYPES OF INVESTMENT PROJECTS
Whether a firm can undertake a depends on the importance of the project to the existing
operations, availability of capital, types of finance to be used
* firm has unlimited funds → all projects increasing value of firm accepted and implemented
* firm capital rationing → only accept projects high on priority list & within budget constraints
Types of projects that may be entered into for strategic financial reasons:
1. Replacement & expansion decisions
- replacement: firm intends to maintain existing level of operations (production)
- new machine may result in improved production operations, costs & ↑ profits
- Expansion: firm intends to ↑ productive capacity to ↑ sales of existing products or to
diversify into new product lines.
- globalisation increased competition forcing firms to diversify into new product lines to
remain competitive
2. Independent projects
- acceptance of one project doesn’t preclude others from being considered (so long as
firm has enough $ & min investment criteria met)
- no competition between independent projects
3. Mutually exclusive projects
- alternatives that serve the same function
- acceptance of one project in a group of mutually exclusive projects prevents all other
projects from the group from being chosen
4. Contingent projects
- acceptance of one project is contingent on acceptance of another
- e.g. electricity company builds power plant, it must also invest in pollution control
equipment to comply with legal environmental requirements
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