Fundamentals of Capital Budgeting and Financial Modelling

I’m intented to explain fundemantal structure of Capital Budgeting herewith. Financial Modelling step is the natural inevitable outcome after the budgeting process. You may find more detailed explanations later in the article.

Capital Budgeting

Capital budgeting is the process that companies use for decision making on Capital Projects those projects with a life of a year or more. It is accepted that, real capital investements of a company describe the company better than its working capital or capital structure. Valuation principles used in capital budgeting are similar to the valuation principles used in security analysis and portfolio management.

Outlines of Capital Budgeting Process

  • First of all investment ideas need to be generated. These ideas could be bring through top to bottom or bottom to top. Idea generation process is quite important step but most of the books or experts overlooking it.
  • Generally these ideas need to be compitable with the company’s overall strategy or expertise. And it also must consider the projects’ timing. Some projects may look good when considered in isolation but maybe undesirable strategically. Because of financial and real soruce issues, the scheduling and prioritizing of projects is important.
  • In post-auditing process, actual results are compared to planned results any differences must be explained.

Basic Principles of Capital Budgeting

  • Decisions simply based on cash flows. The decisions are not based on accounting concepts, such as net income. Furthermore, intangible costs and benefits are often ignored because, if they are real they should result in cash flows at some other time.
  • Timing of cash flows is crucial, Analysts make an extraordinary effort to detail precisely when cash flow occur.
  • Cash flows are based on opportunity costs. What are the incremental cash flows that occur with investment compared to what they would have been without the investment.
  • Cash flows are analyzed on an after-tax basis. Taxes must be fully reflected in all capital budgeting decisions.
  • Financing costs are ignored. This may seem unrealistic but it is not. Most of the time, analysts want to know the after-tax cash flows and the investment outlays are discounted at the “required rate of return” to find the net present value (NPV). Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operation cash flows and capturing the costs of debt in the discount rate.

Required Rate of Return is the discount rate that investors should require given the riskness of the project.

Certain Capital Budgeting Concepts

  • A Sunk Cost is one that has already been incurred. You cannot change a sunk cost. Today’s decisions, on the other hand, should be based on current and future cash flows and should not be affected by prior, or sunk, costs.
  • An Externality is the effect of an investment on other things besides the investment itself. Frequently, an investment affects the cash flows of the other parts of the company and these externalities can be positive or negative. If possible these should be part of the investment decision. Sometimes externalities occur outside of the company.

Cannibalization is the negative impact of a company’s new product on the sales performance of its existing and related products. It refers to a situation where a new product “eats” up the sales and demand of an existing product, potentially reducing overall sales, even if sales of the new product are increasing. This can negatively affect both the sales volume and market share of the existing product.

  • An Incremental Cash Flow is the cash flow that realized because of a decision, the cash flow with a decision minus the cash flow without that decision. If opportunity costs are correctly assed, the incremental cash flows provide a sound basis for capital budgeting.

Investment Decision Criterias (i.e. Capital Budgeting Techniques)

  • NPV
  • IRR
  • PI
  • Payback Period
  • Sensivity Analysis
  • Value at Risk
  • Earnings Multiple Approach
  • Real Options Approach
  • Hurdle Rate