Introduction to 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.

TERMS

• Common stock

  Common stock is a form of corporate equity ownership, a type of security.

• Preferred Stock

  Preferred stock (also called preferred shares, preference shares or simply preferreds) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument.

Budgeting helps to aid the planning of actual operations by forcing managers to consider how the 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 co-ordinate the activities of the organization by compelling managers to examine relationships between their own operation 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 to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.

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 financial managers of the firm 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 have 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 profitability of the firm. Plus, a long-term investment, once made, cannot be reversed without significant loss of invested capital. The implication of long-term investment decisions are more extensive than those of short-run decisions because of the time factor involved; capital budgeting decisions are subject to a higher degree of risk and uncertainty than are short-run decisions.