CAPITAL BUDGETING

Capital budgeting decisions represent long-term commitments of substantial amounts of resources. As such, these decisions are of strategic concern to organizations; in a very real sense these decisions affect financial results (returns) of organizations for many years into the future. The capital budget (i.e., the allocation of capital to long-term investment projects) is a key component of an organization's overall planning system which is also referred to as its Master Budget.

Accountants can add value to the capital budgeting process of an organization in at least three ways: (1) development of relevant financial (i.e., cash flow) and nonfinancial information for decision making; (2) the design of an effective post-audit mechanism; and (3) educating small business owners on the value and conceptual superiority of discounted cash flow (DCF) decision models.

In general, managers can optimize an organization's capital budget by using the net present value (NPV) decision model, which compares the present value of cash inflows to the present value of cash outflows. Typically, the discount rate used in DCF models is the organization's weighted-average cost of capital (WACC).

Cash outflows from investments can occur at three points: (1) project initiation —to acquire the investment and begin operations, to provide needed working capital for the project, and to dispose of any replaced or discarded assets; (2) project operation —to cover operating expenditures, any additional investments, and additional working capital; and (3) project disposal — to dispose of the investment, to restore facilities, and to provide training or relocation benefits for personnel whose positions have been terminated. An investment generates net cash inflows during its existence through increases in revenues or decreases in expenses, through recovery of its investment in working capital, and from the disposal of assets. For a profit-seeking organization, all such cash flows should be stated on an after-tax basis. Exhibit 20.14 summarizes the definitions, computation procedures, advantages, and weaknesses of the various capital budgeting decision models covered in the chapter. Some advanced considerations in using DCF models for long-term investment analysis are presented in the appendix to this chapter.

The determination of a project's NPV requires the use of forecasts and assumptions. Sensitivity analysis can be used to determine how sensitive the capital budgeting decision is with respect to these assumptions. The chapter presents three examples of sensitivity analysis: what if analysis, scenario analysis, and Monte Carlo simulation analysis. For control purposes, a comprehensive capital budgeting system should provide as well for the conduct of post-audits.

Finally, managers need to understand that the capital budgeting process is affected by a number of important behavioral considerations. Foremost among these considerations is the conflict that arises from using DCF models for investment decision-making but accrual accounting numbers (such as ROI) for subsequent appraisal of financial performance. The use of EVA ® for performance appraisal and the use of post-audits may help reduce this conflict and achieve greater congruency between the goals of decision makers and the goals of the organization as a whole.