Capital Budgeting

Topics: Net present value, Capital budgeting, Investment Pages: 18 (5574 words) Published: February 16, 2011
Capital budgeting Making decisions having significant future benefits or costs for various entities and their stakeholders.

Capital budgeting is the backbone of financial economics. Related topics in financial economics include: the time value of money, the meaning of net-present value, accounting concepts consistent with present-value calculations, discount rates, and option valuation techniques.

In the public sector, the term is often exclusively associated with infrastructure investments -- plant and equipment. It is more properly associated with all policy choices that have significant, long-term consequences: especially decisions about missions, programs, products, processes, or procedures.

There are standard solutions to several kinds of capital-budgeting problems: make or buy decisions, investment in working capital (especially inventories) decisions, maintenance-level decisions, project selection, the choice of mutually exclusive investments, and investments in plant with fluctuating rates of production. However, the same basic calculus of benefits and costs is supposed to guide all classes policy choices with long-term consequences.

Financial Theory

Financial theory teaches that, in the presence of a capital market where funds can be obtained at a price, welfare will be maximized by the implementation of all policy choices that generate positive net-present values. This means, in part, that the timing of benefits and costs is generally of no importance. Most students of financial economics further assert that capital budgeting decisions should also be independent of the source of financing -- value will be the same regardless of whether it is financed with debt, equity or taxes.

Taken together these two assertions imply that all capital budgeting decisions should be governed by cost-benefit analysis, which says: do it whenever benefits exceed costs.

Budget Processes

The institutional arrangements through which capital budgeting decisions are made in the private sector are often analogous to the authorization/appropriations processes of the federal government of the United States. Indeed, Donaldson Brown, then chief financial officer of the General Motors Corporation, explicitly referenced the authorization/appropriations processes of the federal government when he created the first modern procedure for the allocation of capital funds between corporate divisions in 1923. Under Brown’s system, appropriation requests had to include detailed plans of the buildings, equipment, materials required, the capital needed, and the benefits to be achieved from the appropriation. A general manager’s signature was sufficient authorization for a request below a certain amount. However, all very large projects required the approval of the GM’s Executive Committee.

Prior to 1981, when the General Electric Corporation restructured and decentralized operations, capital budgeting at GE followed a similar procedure. First came strategic planning which authorized organizational units to undertake various initiatives. This process produced tentative income targets for each business unit and allocations of capital from corporate headquarters to sectors, sectors to strategic business units, and from strategic business units to divisions. Commitment was provided in the next step of the capital-budgeting process, which authorized sponsoring managers to encumber funds to carry out initiatives. Division managers could appropriate up to $1 million for each initiative, sector executives $6 million, and the CEO $20 million; larger amounts had to be appropriated by the Board of Directors. The appropriator was supposed to ascertain that the strategic purpose behind the initiative was valid and then determine that the proposed initiative was optimally designed for its purpose.

Differences between Capital Budgeting Processes in Business and Government

Despite certain similarities, the...
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