Capital Budgeting

In this lesson, you’re expected to learn about:
– the rate of return
– managing capital allocations
– stock management

Just about everything on which companies spend is considered an investment so every dollar a company spends should contribute to the increased value of the business in some way. But that’s not always the case because many companies are wasteful with their resources.

In reality, you don’t need to measure the returns on every single dollar – it’s not essential to know.

However, when dealing with large expenditures, you need to consider potential returns and capital budgeting. For example, when a company is considering buying a building, new machinery or starting a new project. All these undertakings need to be analyzed carefully from a financial standpoint to determine their potential returns and risk before any action is taken.

What is Capital Budgeting?

Capital budgeting is the process by which you evaluate the financial potential for each of one or more possible capital investments.

In cases where several options are available but the company has enough resources to pursue only one, each option has to be compared against the others in order to determine which one may yield the greatest returns.

The implications of the evaluation go beyond simply making allocation decisions. The information that you derive from these financial valuations plays a big role in the financial projections for the entire company, its resource budgeting, its liquidity and asset management.

The exact nature of the company’s capital investments determines what production volume the business is capable of handling, how profitable and financially efficient it’s going to be, and even how it sets its pricing strategies. The operational and cost efficiencies that the entire company experiences are largely influenced by its capital budgeting decisions.

Rate of Return

This is the ratio of revenues to costs associated with purchasing something. If it’s positive, you’re making more money than you’re spending. When you carry out capital budgeting, the first thing to do is determine the rate of return on a potential investment.

This approach allows us to easily eliminate any potential investments that won’t be profitable or will be significantly less profitable than other options.

For example, if an investment can hope to generate only 1% annual returns per year but a local credit union pays 3% per year on a savings account, you’re better off putting the money in the savings account. So, you want to work out exactly what kind of potential each project has before you do anything else with your information because that helps you avoid a lot of extra unnecessary work.

In order to calculate the rate of return, you need data on the following:

Investment costs, lifespan, operating costs, output volume, pricing and financing costs, revenues, scrap value.

[Optional] Rate Of Return
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A new capital item is likely to be expensive to buy and maintain. Costs to consider are:
– purchase cost
– interest rate you pay on the loan you take to buy the asset
– cost of maintaining the asset

After you calculate your costs, you need to work out your revenue. You need to be concerned with two major types of revenue:
– sales of any product the asset makes
– residual value when you come to get rid of the asset

Calculating the Accounting Rate of Return 

The simplest rate of return to calculate is the accounting rate of return (ARR), a fundamental calculation to determine how much value an investment generates for the company and its owners. The ARR requires only two pieces of information:
– the amount of earnings before interest and taxes (EBIT) generated by the project.
– the cost of the investment.

ARR = EBIT attributed to the project / Net investment 

Transfer Pricing 

Transfer pricing estimates the market value of each step in the process by doing some research to find out the cost of hiring some other company to perform that step.

It helps you do your capital budgeting by determining the amount of added value for that single step and the amount of EBIT you can attribute to that step, to make sure that the investment really is going to generate a positive return on investment.

Transfer pricing determines the fair market value of performing that step to see whether your company is being financially efficient. If some other company can perform that step better or more cheaply, you should probably outsource it to them.

If you know the lifespan of the project, you can forecast the rate of return you experience each year. Whether you’re successful at this forecast or not depends entirely on how closely your forecasts match the actual rate of returns.

The total rate of return on the investment is the total EBIT generated by that investment divided by the cost of the investment. The revenues used to calculate EBIT include all the revenues that the investment generates over its entire life, plus the final revenue generated using its residual or scrap value.

Net Present Value

Managing the project’s value 

When you take the NPV of a project at time t, you can add the actual returns generated up until that point and more closely manage the project’s value. Forecasts are always estimates, some more accurate than others, and so when the period for a forecast is over or is in the process of passing, you want to check and see how close you were to the forecast. The net cash flows generated so far are called earned value, which is calculated as follows:
EV = ∑ PV 

Essentially, this equation says that you take all the present values you’ve completed and add them together.

Tracking the NPV of a given project allows you to manage the project more effectively, manage finances and resources more efficiently and plan better for the future. These tasks form the fundamentals of project management.

Determining Payback Period 

Payback period is the number of periods needed to pay back the initial investment on a piece of capital. It’s the number of years for a company to break even on its new capital investment. This figure is a crucial calculation not only for projecting cash flows, interest payments and other value management techniques for the investment, but also for projecting the influence of the project on the entire company’s asset management and profitability.

Payback = Initial investment / Net annual cash flows   

Suppose that you spend $10,000 on a piece of capital. This piece of capital is expected to generate, on average, an extra $1000 in EBIT to your company and has a lifespan of 20 years. Thus, your payback period on this piece of equipment would be:
$10,000 / $1000 = 10 years

Equivalent Annual Cost

Let’s start by calculating the equivalent annual cost of each potential investment.

Equivalent annual cost can be calculated as follows:
EAC = NPV / [1 – (1 + Discount rate)^-n] 

This equation allows you to compare the annual costs of potential with differing duration periods and cash flows. The real test of whether or not any of the potential investments are going to be successful however, depends greatly on the ability of the company to derive value from the project.

Capital Efficiency

Another thing to consider is capital efficiency.
CE = Output / Expenditures

When you have an idea of the amount of output being generated by an actual project, you can determine the amount of cash flows at a given rate of efficiency and the degree to which that efficiency must increase in order to increase the NPV of the project. You then use the estimate at completion value to determine which one of several potential investments is going to generate the greatest returns for the company.

Liquid Assets 

Liquid asset management is the frequent analysis of whether a firm is better off allocating resources towards liquid assets, with low returns but low risk, or to long-term assets, which usually have higher returns but higher risk.

Allocating resources and assets into capital investments is about more than just long-term assets. Although these assets tend to get the most attention, because of their high cost and higher risk, you also need to evaluate liquid assets for their performance and returns. Whether you put money into a long-term asset or a liquid account is determined, in large part, by the amount of liquidity risk the company is facing as well as its estimated future cash flows.

Economic Capital

Companies want to generate the highest rate of returns that they can. Of course, this goal is impossible given the timing of their costs and expenditures, and also they need to maintain a type of short-term liquid assets: economic capital. Economic capital is all the money that’s kept in banks, cash or anything else that you can use immediately to pay for daily cash requirements.

Money that isn’t kept in economic capital is money that isn’t put into investments. Therefore, carefully assessing liquidity risk, cash requirement and future cash flows is an important part of efficiently using your assets to generate returns.


The other form of liquid asset you need to consider is stock (also referred to as inventory). Stock includes all the assets that are going to be sales, including finished products, work-in-progress and raw materials.

These assets not only keep a company from investing but also cost money to keep in storage. That’s why many companies are now paying attention to and innovating in the field of stock management. The ultimate goal is just-in-time stock management.

Just-In-Time (JIT) Stock Management

To understand what JIT means, let’s look at the vartious stages of production.

Each phase has its own costs and valuations. JIT works to reduce the costs associated with each step as much as possible, ensuring that the final output for the sale receives its stock just as it runs out – ideally in small quantities delivered frequently.

1) Finished products: Products that are ready to be sold. They’re completely finished and storing them until they’re bought costs money. Direct sales tend to be cheaper because the costs of storage and distribution are lower without retailers.

2) Work in progress: products that have been started but aren’t complete yet. Decreasing the amount of time in-progress can cut costs and increase rates of return.

3) Raw materials: Materials that haven’t yet begun to be processed. The majority of stock management is focused here, ensuring that materials don’t arrive before they’re really needed.

The cost of stock comes primarily from storage. Jut like any other capital investment, the increased expenditures required for space to store and maintain stock, known as the cost of stock, can reduce the rate of returns generated by selling this form of stock as capital. JIT attempts to manage the supply chain by ensuring that stock in its various forms arrives immediately when it’s needed. This strategy ensures that stock remains available while reducing the costs associated with stock.

Applying NPV to stock management allows you to see that JIT can dramatically increase the rate of returns on capital. By shortening the duration of capital in stock, the NPV of stock increases almost instantly. This results in the following:
– companies can generate returns on the money that otherwise would’ve been allocated to stock in the meantime.
– companies can reduce the opportunity costs associated with short-term liquid assets.

[Optional] An Introduction to Capital Budgeting
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