Managerial economics guide 9

Capital budgeting

Capital budgeting is about making analysis over the purchase or realization of projects that extend over a time rate (normally 1 year).

Projects

We are talking about different kinds of projects, which we can group into two types:

I. Replacement projects

Projects to replace equipment and capital which are worn out and can't be reused. If you want your firm to operate as before, you have to replace them.

II. Expansion projects

You want to understand whether there is a reason to expand the scale of productivity, maybe in the exact same sector you are operating or linked to what you are operating. This is the most important kind of project because it is more complex and requires a forecast about future demand and the future conditions needed for expansion: capital, market, etc., that make expansion projects more difficult to plan.

Other kind

Routine projects involve new safety rules, agreements to be made, or environmental projects which are less challenging.

Sequence of capital budgeting steps

• Estimating costs: Costs can be computed or estimated because cost is not guaranteed to occur only at the beginning of the project but also during the life and at the end of the project. If that is the case, you will need to make forecasts/estimations about future costs.
• Estimate revenue over time: Revenue is also related to cost, so you have to understand the riskiness of these inflows.
• Estimate the distribution of such revenue.
• Given project risk and market conditions, figure out an appropriate required rate of return for the project.
• Discount inflows and possibly outflows and "compare" discounted inflows and outflows.

The idea is to estimate costs and then cash inflows. We have to determine the distribution for cash inflows and then, out of the distribution, come up with a notion of risk, adjust the cost of capital in respect to risk, then apply the cost of capital and the rate of adjusted return to the investment to discount cash inflows and possibly cash outflows. When cash outflow occurs toward the end of a project, think about a well which has to be refilled in the end, a huge cost which comes in at the end of the project life and not the beginning.

With respect to the fact that you first have outflow and then inflow, you tend to distinguish between two classes of project:

• Conventional: +outflows at the beginning and inflows later on
• Unconventional: +inflows at the beginning and outflows later on

They create some differences in terms of what you get at the end of the project. You then apply the cost of capital to discount inflows and outflows and then you compare inflows to outflows in various ways.

We have to consider:

• Incremental cash flows: They pertain only to new investments; they will not exist if the new investment is not carried out. You can address cash flow by turning to different types of performance statements; the cash flow statement basically refers to income. You want to convert your net income into cash flow.

You have the first performance cash flow statement with the new investment and then you make up another performance cash flow statement without the new investment. The difference between the two statements gives you the incremental cash flow. This is the only one that has to be taken into consideration.

Once we have our cash flows, inflows, and outflows denoted as:

• Cash inflow of investment at time t
• Cash outflow of investment in terms of cost at time t

Evaluation tools

Net present value (NPV)

Net present value is the most frequently used technique and it makes use of the fundamental formulas in financial economics. The value of an asset is simply the sum of the flows from the asset. Have a clear idea of what is and are; normally it's more complicated to understand cash flow 5 years from now or 10 years from now, so randomness is much more important. This may depend less on market circumstances and more on market factors which are more difficult to control.

Expected cash inflows is equal to:

∑ (inflows) - ∑ (outflows)

This is simply the sum of inflows minus the sum of outflows, which are all discounted because the amount of money today is not the same tomorrow. You have to define wealth not only in terms of money but also in terms of situations and circumstances in which the sum of money is available. NPV is a criterion which allows you to:

• Analyse projects that are independent, which means that you can implement them all. In which case, you may want to rank them or maybe just try to understand their value individually (are they worth pursuing or not).
• Analyse mutually exclusive projects, which cannot be carried out at the same time. For example, you want to use a plot of land for something: so either opening an amusement park or a parking lot.