Basic Principles of Capital Budgeting

PFS has started its comprehensive classes for CFA Level I candidates targeting the Dec 2020 CFA Level I Exam. The class schedules and plans are already shared to our clients and via our blog. Because of COVID-19, we are having classes via zoom. We will go back to our offline classes soon after the lockdown periods are over. We are also opening another batch targeting Feb 2021 CFA Level I Exam. This will be the first computer-based exam to be organized by CFA Institute.

We have started our first class today, and we have covered two chapters from corporate finance, capital budgeting, and cost of capital. We have discussed all the learning outcomes of the chapters and a practice exam will take place next week.  I will share the basic principles of capital budgeting in this section. One can also watch an excerpt from our class to know about the principles.

Basic Principles of Capital Budgeting

Decisions are based on cash flows, not based on accounting net income: Capital budgeting decisions focus on analyzing cash flows, not the accounting net income.

Timing of cash flows is important: The timing of the cash flows is important. The earlier a project receives the bigger cash flows the better.

Cash flows are compared relative to opportunity costs: Cash flows are compared based on the opportunity costs of other projects. In case of discounting the cash flows opportunity cost of capital is used.

After-tax cash flows are considered, not before tax cash flows: After-tax cash flows are the cash flows that belong to the suppliers of capital.

Focus is on after-tax operating cash flows by ignoring the financing costs: Financing costs are captured in the required rate of return. After-tax operating cash flows belong to all the suppliers of capital. That is why after-tax cash flows are discounted using a weighted average cost of capital (WACC). Financing costs are already incorporated in WACC. To avoid double-counting, the numerator uses after-tax operating cash flows.

Capital budgeting cash flows don’t consider accrual income or expenses: Non-cash chargers, for example, depreciation, amortizations are ignored since we only focus on cash flows, not the accrual income/expenses.

Sunk costs should be ignored: Sunk costs are costs that are already incurred and cannot be recouped whether or not we enter into a project. Since the costs are already incurred and cannot be altered, they should not be considered in capital budgeting decision making.

Incremental cash flows are considered: Incremental cash flows should be considered in capital budgeting decision making. For example, for replacement projects, the cash flows from the new equipment minus the cash flows from the old equipment should be considered. When evaluating costs again, we should consider the incremental costs.

Externalities are considered in investment decision making: An externality is the effect of an investment on other things besides the investment itself. There are two types of externalities. Positive externalities and Negative externalities. Cannibalization is one type of externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company. If possible, we should consider externalities in investment decision making.

4 thoughts on “Basic Principles of Capital Budgeting”

  1. Excellent way of explaining, and nice article to obtain data concerning my presentation subject matter, which i am going to deliver in academy. Eachelle Tobie Iline

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