Budgeting, capital budgeting

Budgeting is the process of developing budgets, or finan­cial plans that project a firm’s inflows and outflows for a future time period. Often budgeting results in the con­struction of pro forma statements, namely the budgeted INCOME STATEMENT and the budgeted BALANCE SHEET.Pro forma, as a matter of form, statements have generally accepted formats but are based on projections. A budgeted (pro forma) income statement is one that reflects projec­tions rather than being based on prior transactions; thus it represents expectations rather than actual data. Likewise, a budgeted (pro forma) balance sheet is one that is con­structed using projections rather than actual data. Pro-forma statements are important tools used in planning and decision-making. In banking, pro forma statements are commonly used as the basis for making loans of VENTURE CAPITAL and loans to new businesses.

Capital budgeting is the planning for a firm’s fixed ASSETS in particular. How a firm decides to use its capital is the most important of all managerial decisions, and since fixed assets represent the majority of most firms’ assets, capital budgeting is the most crucial of all budget­ing activities.

While there are infinite uses for a firm’s capital, its sources are limited, and capital budgeting determines its best uses. Payback period, net present value (NPV), and internal rate of return (IRR) are three capital-budgeting tools commonly used to determine a firm’s most profitable INVESTMENT opportunities.

Payback period, the first capital budgeting tool to be developed, is the expected number of years required for a firm to recoup its original investment in a fixed asset or project. The decision rule when using payback is that shorter payback periods are preferable over longer ones. For example, suppose Project A requires an investment of $10,000 and will generate cash inflows of $3,000 per year for the next five years. Assuming that these inflows are evenly distributed over the next five years, the payback period for Project A is $10,000/$3,000 = 3.33 years. Sup­pose Project Z costs $10,000 and will generate cash inflows of $2,000 per year for the next 10 years. The pay­back period for Project Z is $10,000/$2,000 = 5 years. If payback is used to rank these two projects, Project A is the preferred investment opportunity because of its shorter payback period.

There are two major shortcomings of payback period as a capital-budgeting tool. Only the inflows required to recoup the original investment are considered; the inflows occurring after the payback period are ignored. For Project A above, returns continue for an additional 1.67 years beyond the payback period, but they aren’t considered. For Project Z, returns continue for another five years beyond the payback period. Payback is particularly flawed when used to evaluate investment opportunities where the returns are slow for the first couple of years, but become significant in later years.

An even more serious flaw is that payback is not a dis­counted cash flow technique; it ignores the time value of money. In Project Z, for example, the $2,000 received in

Year 5 is viewed as just as valuable as the $2000 received in Year 1. Depending on the DISCOUNT RATE (cost of capital for the firm) used to determine the present value of the cash inflows, Project Z may, in reality, be a more profitable invest­ment. This makes payback period a crude tool for evaluat­ing and ranking profitable investment opportunities.

To incorporate the time value of money in capital budg­eting, NPV and IRR were developed. These are discounted cash-flow techniques and are more valid tools for decision making than payback period.

NPV is the present value of a project’s future cash inflows minus the initial cash outflow (original invest­ment) required. The decision rule is to accept the project if its NPV is positive but reject if it is negative. If projects are not mutually exclusive, those with greater NPVs are ranked more preferable than those with lower NPVs. Sup­pose a project’s NPV is +$50,000. The present value of the project’s inflows are $50,000 greater than its initial cost, and this net return accrues to the firm’s owners.

IRR, also a discounted cash-flow technique, is similar to NPV except that, while NPV is expressed in dollars, IRR is expressed in percentages. IRR is the discount rate that equates the present value of a project’s expected inflows and its cost. The decision rule to follow when using IRR is to accept projects where the IRR is greater than the firm’s cost of capital and reject those opportunities where the IRR is less than the firm’s cost of capital. For example, if a project’s IRR is 20 percent for a firm whose cost of capital is also 20 percent, undertaking and investing in the proj­ect will add nothing to the firm’s PROFITs; the project’s return exactly offsets the cost of the investment in the project. Thus the cost of capital is a “threshold” which must be exceeded when using IRR as a capital budgeting tool. If projects are not mutually exclusive, projects with higher IRRs are ranked more preferable than those with lower IRRs, and projects whose IRR is less than the firm’s cost of capital are rejected.