Introduction to Capital Budgeting

The Goals of Capital Budgeting

The main goals of capital budgeting are not only to control resources and provide visibility but also to rank projects and raise funds.

Budgeting provides a forecast of revenues and expenditures, constructing a model of how a business might perform financially if certain strategies, events, and plans are carried out. It enables the actual financial operation of the business to be measured against the forecast and establishes the cost constraint for a project, program, or operation.

Budgeting helps to aid the planning of actual operations by forcing managers to consider how conditions might change and what steps should be taken in such an event. It encourages managers to consider problems before they arise. It also helps coordinate the activities of the organization by compelling managers to examine relationships between their own operations and those of other departments.

Other essential functions of a budget include:

• To control resources.
  
  
• To communicate plans to various responsibility center managers.
  
  
• To motivate managers to strive to achieve budget goals.
  
  
• To evaluate the performance of managers.
  
  
• To provide visibility into the company's performance.

Capital Budgeting, as a part of budgeting, more specifically focuses on long-term investment, major capital, and capital expenditures. The main goals of capital budgeting involve:

Ranking Projects

The real value of capital budgeting is ranking projects. Most organizations have many projects that could potentially be financially rewarding. Once determined that a particular project has exceeded its hurdle, it should be ranked against peer projects (e.g., from highest to lowest Profitability index). The highest-ranking projects should be implemented until the budgeted capital has been expended.

Private Equity Private equity firms, such as NBGI, provide funds for companies that are unable or uninterested in obtaining funds publicly.

Raising Funds

When a corporation determines its capital budget, it must acquire funds. Three methods are generally available to publicly traded corporations: corporate bonds, preferred stock, and common stock. The ideal mix of those funding sources is determined by the firm's financial managers and is related to the amount of financial risk that the corporation is willing to undertake.

Corporate bonds entail the lowest financial risk and, therefore, generally have the lowest interest rate. Preferred stock has no financial risk, but dividends, including all in arrears, must be paid to the preferred stockholders before any cash disbursements can be made to common stockholders; they generally have interest rates higher than those of corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital projects. The Internal Rate of Return is very important.

Capital budgeting is an important task as large sums of money are involved, which influences the firm's profitability. Plus, a long-term investment, once made, cannot be reversed without significant loss of invested capital. Because of the time factor involved, the implications of long-term investment decisions are more extensive than those of short-run decisions; capital budgeting decisions are subject to a higher degree of risk and uncertainty than short-run decisions.

Goals of Capital Budgeting The main goal of capital budgeting is to rank projects.