The term capital budgeting refers to how a company’s management plans for investment in projects that have long-term financial implications, like acquiring a new manufacturing machine, purchasing a tract of land or starting a new product or service etc. Companies mostly have a number of potential projects that they can actually undertake. Among those projects, managers need to carefully choose the ones that promise the largest future return for their company.
A capital budgeting decision is any managerial decision that involves an investment now in the hope of obtaining a return in future. Since these decisions involve larger financial outlays and longer time horizons, they need to be concluded with considerable thought and care.
A company’s long-term financial health largely depends on how well its management makes the capital budgeting decisions. These decisions typically include the following:
- Expansion decisions – should a new plant, storage area, or another facility be acquired to enhance operating capacity and turnover?
- Cost-cutting decisions – should a new asset be acquired to lower cost?
- Lease or buy decisions – should a new asset be bought or acquired on lease?
- Selection decisions – which of several similar available assets should be acquired for use?
- Replacement decisions – should an existing asset be overhauled or replaced with a new one?
Types of capital budgeting decisions
Capital budgeting decisions can be broadly bifurcated as screening decisions and preference decisions.
(1). Screening decisions
Screening decisions are basically related to acceptance or rejection of a proposed project on the basis of a preset criteria. For example, management may have a policy to accept a project only if it is expected to yield a return of at least 25% on initial investment. Similarly, a project may not be accepted if it does not promise to recover the initial investment within a certain predefined period of its inception, such as within 3, 4, 5 or 6 years etc.
Screening decisions center on whether a proposed project is viable in relation to its profitability and time span involved. In addition, they also suggest the quantum and duration of investment that can potentially maximize the firm’s growth. To get help with screening decisions, managers generally use one or more of the following six capital budgeting methods:
- Net present value (NPV) method
- Profitability index (PI) method
- Internal rate of return (IRR) method
- Simple payback method
- Discounted payback method
- Accounting rate of return (ARR)
(2). Preference decisions
Preference decisions revolve around selecting the best from several acceptable projects. For example, management may be considering a number of different new machines to replace an old one on the manufacturing line. The selection of which machine to acquire is a preference decision.
Preference decisions are about prioritizing the alternative projects that make sense to invest in. They allot the ranks to all acceptable opportunities and keep the most viable and less risky ones at the top spots. These decisions generally follow the screening decisions, which means the projects are first screened for their acceptability and then ranked according to the firm’s desirability or preference.
Since preference decisions center on rationing the available funds among competing projects, they are sometimes referred to as rationing decisions or ranking decisions.
The IRR, NPV and PI are the methods that are generally used by managers to get help with their preference decisions. In case these methods conflict with each other, the PI is considered the most reliable method for preference ranking of proposals.