Basic Principles of Capital Budgeting

Since capital budgeting describes the process by which all companies make decisions on their capital projects, it is not unusual for some fairly sophisticated techniques to be employed in its execution. Regardless of this, capital budgeting relies heavily on just a few basic principles.

Principles of Capital Budgeting

Capital budgeting typically adopts the following principles:

• decisions are based on cash flows, not accounting concepts such as net income;
• the timing of cash flows is critical;
• cash flows are based on opportunity costs. A comparison is made between the incremental cash flows that occur with investment and without the investment;
• cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected in capital budgeting decisions;
• the financing costs are ignored. Financing costs are already reflected in the required rate of return and therefore including them again in the cash flows and the discount rate would lead to double counting; and
• the capital budgeting cash flows are not the same as accounting net income.

Capital Budgeting Concepts

In addition to the basic capital budgeting principles outlined above, there are several concepts that capital managers should be aware of in the capital budgeting process. These include:

• sunk costs: these are costs that have already been incurred;
• opportunity cost: this refers to what a resource is worth if it is put to its next-best use;
• incremental cash flow: this is the cash flow that is realized because of a decision;
• externality: this refers to the ripple effect of an investment. If possible, these effects should be part of the investment decision. Cannibalization is one example of an externality. This occurs when an investment results in customers and sales moving away from another part of a company.
• conventional cash flow versus non-conventional cash flow: a conventional cash flow pattern has an initial cash outflow followed by a series of cash inflows. Conversely, a non-conventional cash flow pattern is one in which the initial cash outflow is not followed by cash inflows only. Instead the cash flows can flip from positive to negative again (or even change signs several times).

Question

Which of the following statements is most likely accurate?

1. In capital budgeting, only pre-tax cash flows should be considered.
2. The timing of cash flows is crucial to the capital budgeting process.
3. A non-conventional cash flow pattern is one that has an initial cash outflow followed by a series of cash inflows.

Solution

The correct answer is B.

Capital budgeting analysts make an extraordinary effort to detail precisely when cash flows occur.

A is incorrect because cash flows are analyzed on an after-tax basis; taxes have to be fully reflected in capital budgeting decisions.

C is incorrect because a conventional cash flow pattern (not a nonconventional cash flow pattern) is the one which has an initial cash outflow followed by a series of cash inflows.