Capital budgeting is part of the management planning process, an analysis of evaluating a company's long-term investment opportunities. As with every budgeting situation, amounts must be estimated for planning to take place. A number of cash flows are involved with capital budgeting, including the cost to acquire a capital asset, the cash to be generated and cash to be used in operating the asset, and the cash to be received when the asset is disposed of a the end of its useful life.


Types of Capital Budgeting Decisions

Capital budgeting helps managers assess if a long-term asset or investment should be acquired. Long-term assets include property, plant, and equipment (PP&E) such as land, land improvements, buildings, computers, equipment, and vehicles, and intangible assets such as patents, trademarks, and copyrights. Recall from financial accounting that long-term assets are 'capitalized' and reported as long-term assets on a company's balance sheet. Because they are expected to benefit a company for more than one accounting period---typically several years, companies must allocate the cost of most capital assets over time as an expense by depreciation or amortization.


Some typical capital budgeting decisions include:

Expansion decisions, such as a subsidiary purchase

Equipment purchase decisions

Leasing versus buying

Cost reduction decisions, such as a new machine to replace employees

While many long-term assets are purchased by signing a note payable and then making payments on a monthly or annual installment basis similar to a car loan, this chapter will make the assumption that the company plans to pay the entire cost on the date of the acquisition. Financing situations are beyond the scope of this course, and will be covered in your first finance class next semester.


Basic Financial Accounting Review - Accounting for Long-Term Assets

Upon acquisition, a long-term asset should be capitalized by:

Increasing the respective Asset account with a debit, and

Decrease cash with a credit.

The amount to debit to the asset account should include all costs necessary to get the asset ready to use. This includes sales taxes, transportation costs, installation costs, and other costs incurred up to the point that the asset is placed into service. The cost is reported in the Long-Term Assets section of the balance sheet, as either Property, Plant, and Equipment, or as an Intangible Asset. It is also reported as an outflow in the investing activity section of the statement of cash flows. 


Managers must estimate the time period over which a long-term asset is expected to provide benefits for the company. The time period should correlate to the time over which the company expects to earn revenues and cash inflows. The capitalized cost of the asset is then allocated (i.e., depreciated or amortized) over that estimated life. Companies can choose from straight-line, double-declining balance, or a few other GAAP methods of depreciation. The cost of most intangibles is amortized equally over the shorter of the legal or estimated useful life.


Methods of Evaluating Capital Budgeting Decisions

There are four methods of evaluating capital budgeting projects:

1.    Net present value (NPV)

2.    Internal rate of return (IRR)

3.    Payback period method (PBP)

4.    Accounting rate of return (ARR)

Two of these methods include time value of money as part of the analysis--the net present value method and the internal rate of return method.


Time Lines

All capital budgeting problems begin by drawing a time line. The time line illustrates at what point in time each cash flow is expected to occur. Cash inflows are shown as positive amounts. Cash outflows are shown as negative amounts by enclosing in parentheses. Inflows increase a company's total cash. Outflows decrease a company's total cash.


There are two types of cash flows involved in capital budgeting decisions---operating and investing cash flows. Both types of cash flows will appear on the timeline. Categorizing cash flows as operating or investing is based on the same concepts as you learned in financial accounting in preparing the statement of cash flows.


Operating Cash Flows

Operating cash flows are those that result from activities relating to operations. Operations are a company's normal business activities, the same type of activities reported on the income statement. Because capital acquisitions impact several years, you must identify the net cash flows by year. The cash inflow amounts are netted with the cash outflow amounts for each year. Net cash inflows (cash inflows exceed cash outflows) are preferred, though net outflows may result when cash outflows exceed cash inflows for a particular year. 


Investing Cash Flows

Investing cash flows are those that involve the acquisition or disposition of long-term assets that are used in the production of income. There are three potential investing cash flows in capital budgeting.


The first investing cash flow is the cost of the proposed asset acquisition. Because this chapter assumes that capital acquisitions are paid for using cash and not financed, we will assume the entire purchase price is a cash outflow on the date the new asset is expected to be acquired. The proposed acquisition date dictates the beginning of the time line and represents the beginning of the useful life chosen for the asset acquisition. This date is referred to as 'time zero.'


A second investing cash flow occurs at the end of the useful life of the proposed asset. This cash flow is the salvage value, which represents the amount a manager thinks the cash value for which the asset will be sold at the end of its useful life. This cash flow is also know as residual value.


The third possible investing cash inflow relates to cash received from the sale of an old asset that is being replaced. Recall that disposing of an old asset often generates a gain or loss on the sale in addition to a cash inflow. Any gain or loss impacts net income, and is not a cash flow. Only the cash to be received from the sale of the old asset is an investing cash flow.


This page was last edited on Wednesday December 31, 2014 12:15 PM
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