The 6 Principles of Capital Budgeting
On the CFA Level 1 exam you will be asked to calculate all the key metrics around evaluating a capital project and interpret the decision rules for each method around whether a firm should undertake a given project. This first came up in the discounted cash flows reading in Quantitative methods.
Capital budgeting is the process of determining whether a firm should undertake a long-term investment (where we define long-term investment as any project where the cash flows are expected to occur for more than one year).
Thus capital budgeting includes things like acquiring new machinery or replacing existing ones, launching new products, or spending on R&D. We can break this into five major categories, where the level of complexity around decision-making is different for each:
- Replacement projects – Projects to maintain the business. Usually made without detailed analysis. Cost reduction/enhancement replacement projects do require detailed analysis however
- Expansion projects – Projects to increase the size of the business are complex and require detailed projections of future demand
- New Product / Markets – Lots of uncertainty thus must include detailed analysis
- Mandatory Projects – Often mandated by governments/insurance for regulatory/safety/environmental reasons. These may not be revenue generating
- Other – Pet projects or moonshots
Basically the more complex a project or the more significant a company’s expenditures the more analysis is required.
At its heart this is a cash flow problem. A firm is making an upfront investment today in expectation of future streams of income. The idea is that any project where the net present value of these future cash flows is greater than the initial cash outlay will increase shareholder value and vice versa.
CFA Level 1 Principles for Capital Budgeting
There are six key principles in evaluating capital budgeting projects:
- Decisions are based on incremental cash flows not accounting income
Where incremental cash flow is the additional cash flow realized as a result of a decision and equals the new CF minus the CF if the decision had not been made.
- We consider after-tax cash flows based on opportunity costs
We only care about the cash a firm will actually receive, not the cash it will pay in taxes. A firm’s opportunity cost is defined as the value of the next best alternative that is NOT undertaken as a result of the project. Often this is the interest a firm would have received if it had invested the capital. Opportunity costs should be included in overall project costs.
- We do not consider sunk costs, e. we think on the margin
Where sunk costs are costs that have already been incurred and cannot be recovered.
- Externalities including cannibalization are important (cannibalization is when a new project takes revenue away from an existing product)
- The timing of cash flows is critical (i.e. the NPV calculation considers the time value of money)
- The discount rate in the calculation takes into consideration the firm’s cost of capital