Stages of Capital Budgeting

Learning Objective 1 Understand the five stages of capital budgeting for a project

• identify projects; obtain information; make predictions; make decisions; and implement the decision, evaluate performance, and learn

Capital budgeting is the process of making long-run planning decisions for investments in projects. In much of accounting, income is calculated on a period-by-period basis. In choosing investments, however, managers select from among multiple projects, each of which may span several periods. Exhibit 22-1 illustrates these two different yet intersecting dimensions of cost analysis: (1) horizontally across, as the project dimension, and (2) vertically upward, as the accounting-period dimension. Each project is represented as a horizontal rectangle starting and ending at different times and stretching over time spans longer than 1 year. The vertical rectangle for the 2021 accounting period, for example, represents the dimensions of income determination and routine annual planning and control that cut across all projects that are ongoing that year.

To make capital budgeting decisions, managers analyze each project by considering all the life-span cash flows from its initial investment through its termination. This process is analogous to life-cycle budgeting and costing (Chapter 14). For example, when Honda considers producing a new model of automobile, it begins by estimating all potential revenues from the project as well as any costs that will be incurred during its life cycle, which may be as long as 10 years. Only after examining the potential costs and benefits across all of the business functions in the value chain, from research and development (R&D) to customer service, across the entire life span of the new-car project does Honda decide whether the new model is a wise investment.

Managers use capital budgeting as a decision-making and a control tool. Like the five-step decision-making process that we have emphasized throughout this text, there are five stages to the capital budgeting process:

1. Stage 1: IDENTIFY PROJECTS. Identify potential capital investments that agree with the organization’s strategy. For example, Nike, an industry leader in product differentiation, makes significant investments in product innovation, engineering, and design, hoping to develop the next generation of high-quality sportswear. Alternatively, managers could promote products that improve productivity and efficiency as a cost-leadership strategy. For example, Lenovo’s strategy of cost leadership includes outsourcing certain components to lower-cost contract manufacturing facilities located overseas. Identifying which types of capital projects to invest in is largely the responsibility of a firm’s top managers.
2. Stage 2: OBTAIN INFORMATION. Gather information from all parts of the value chain to evaluate alternative projects. Returning to the new car example at Honda, in this stage, the firm’s top managers ask the company’s marketing managers for potential revenue numbers, plant managers for assembly times, and suppliers for prices and the availability of key components.
3. Lower-level managers are asked to validate the data provided and to explain the assumptions underlying them. The goal is to encourage open and honest communication that results in accurate estimates so that the best investment decisions can be made. Some projects will be rejected at this stage. For example, suppose Honda learns that the car cannot be built using existing plants. It may then opt to cancel the project altogether. At AkzoNobel, a global paints and coating company, the chief sustainability officer reviews projects against a set of environmental criteria and has the power to reject projects that do not meet the criteria or lack an acceptable explanation for why the company’s sustainability factors were not considered.
4. Stage 3: MAKE PREDICTIONS. Forecast all potential cash flows attributable to the alternative projects. A new project generally requires a firm to make a substantial initial outlay of capital, which is recouped over time through annual cash inflows and the disposal value of the project’s assets after it is terminated. Consequently, investing in a new project requires the firm to forecast its cash flows several years into the future. BMW, for example, estimates yearly cash flows and sets its investment budgets accordingly using a 12-year planning horizon. Because of the significant uncertainty associated with these predictions, firms typically analyze a wide range of alternate circumstances. In the case of BMW, the marketing group is asked to estimate a band of possible sales figures within a 90% confidence interval. Firms also attempt to ensure that estimates, especially for the later years of a project, are grounded in realistic scenarios. It is tempting for managers to introduce biases into these projections in order to drive the outcome of the capital budgeting process to their preferred choice. This effect is exacerbated by the fact that managers may not expect to be employed at the firm during those later years and therefore cannot be held accountable for their estimates.
5. Stage 4: MAKE DECISIONS BY CHOOSING AMONG ALTERNATIVES. Determine which investment yields the greatest benefit and the least cost to the organization. Using the quantitative information obtained in Stage 3, the firm uses any one of several capital budgeting methodologies to determine which project best meets organizational goals. While capital budgeting calculations are typically limited to financial information, managers use their judgment and intuition to factor in qualitative information and strategic considerations as well. For example, even if a proposed new line of cars meets its financial targets on a standalone basis, Honda might decide not to pursue the line if it is not aligned with the strategic imperatives of the company on matters such as brand positioning, industry leadership in safety and technology, and fuel consumption. Considerations of environmental sustainability might also favor certain projects that currently appear unprofitable. Freight and logistics giant UPS relaxes the company’s minimum rate of return on vehicles that have the potential to reduce fuel use and costs. Similarly, Sealed Air is willing to accept projects with a lower projected return if they look promising with regard to reducing greenhouse gas emissions. For another example, see Concepts in Action: AkzoNobel Integrates Sustainability Into Capital Budgeting. Finally, managers spend a significant amount of time assessing the risks of a project, in terms of both the uncertainty of the estimated cash flows as well as the potential downside risks of the project (including to the firm as a whole) if the worst-case scenario were to occur.
6. Stage 5: IMPLEMENT THE DECISION, EVALUATE PERFORMANCE, AND LEARN. Given the complexities of capital investment decisions and their long time horizons, this stage can be separated into two phases:
   1. • OBTAIN FUNDING AND MAKE THE INVESTMENTS SELECTED IN STAGE 4. The sources of funding include internally generated cash as well as equity and debt securities sold in capital markets. Making capital investments is often an arduous task, laden with the purchase of many different goods and services. If Honda opts to build a new car, it must order steel, aluminum, paint, and so on. If some of the materials are unavailable, managers must determine the economic feasibility of using alternative inputs.
   2. • TRACK REALIZED CASH FLOWS, COMPARE AGAINST ESTIMATED NUMBERS, AND REVISE PLANS IF NECESSARY. As the cash outflows and inflows begin to accumulate, managers can verify whether the predictions made in Stage 3 agree with the actual flows of cash from the project. Snap Inc. saw disappointing advertising revenues and monthly active users in 2018 due to its ill-received app redesign and loss of market share to Facebook Inc.’s Instagram Stories. As a result, Snap introduced a suite of new products and services, including an ad-supported gaming platform.
   3. It is equally important for a company to abandon projects that are performing poorly relative to expectations. Managers have a natural bias to escalate their commitment to a project they chose to implement for fear of revealing they made an incorrect capital budgeting decision. It is in the firm’s and the managers’ long-term interest, however, to acknowledge the mistake when it is clear that the project is not financially sustainable. For example, in July 2017, a consortium of companies cancelled the $29 billion Pacific Northwest LNG project to build a natural gas liquefaction and export facility in British Columbia, Canada. Petronas, the Malaysian energy company, led the project with a 62% stake and lost an estimated $800 million for work already done. The project was cancelled due to low natural gas prices and changes in the energy market.

To illustrate capital budgeting, consider Vector Transport. Vector operates bus lines throughout the United States, often providing transportation services on behalf of local transit authorities. Several of Vector’s buses are nearing the end of their useful lives and now require increased operating and maintenance costs. Customers have also complained that the buses lack adequate storage, flexible seating configurations, and newer amenities such as wireless Internet access and personal entertainment systems. The firm has made a commitment to act in an environmentally responsible manner and will only pursue projects that do minimal harm to the ecosystem. Accordingly, in Stage 1, Vector’s managers decide to look for replacement buses that generate low emissions. In the information-gathering stage (Stage 2), the company learns that as early as 2020, it could feasibly begin purchasing and using diesel-electric hybrid buses that have Wi-Fi and also offer greater comfort and storage. After collecting additional data, Vector begins to forecast its future cash flows if it invests in the new buses (Stage 3). Vector estimates that it can purchase a hybrid bus with a useful life of 5 years for a net after-tax initial investment of $648,900, which is calculated as follows:^*

Working capital refers to the difference between current assets and current liabilities. New projects often require additional investments in current assets such as inventories and receivables. In the case of Vector, the purchase of the new bus is accompanied by an incremental outlay of $30,000 for supplies, replacement batteries, and spare parts inventory. At the end of the project, the $30,000 in current assets is liquidated, resulting in a cash inflow. However, because of the rapid nature of improvements in hybrid technology, the bus itself is believed to have no terminal disposal value after 5 years.

Managers estimate that by introducing the new hybrid buses, operating cash inflows (cash revenues minus cash operating costs) will increase by $180,000 (after tax) in the first 4 years and by $150,000 in year 5. This arises from higher ticket prices and increases in ridership due to new customers who are drawn to the amenities of the hybrid bus, as well as savings in fuel, maintenance, and operating costs. To simplify the analysis, suppose that all cash flows occur at the end of each year. Note that cash flow at the end of the fifth year also increases by $\mathrm{\$}\text{180,000}-\mathrm{\$}\text{150,000}$ in operating cash inflows and $30,000 in working capital. Management next calculates the costs and benefits of the proposed project (Stage 4). This chapter discusses four capital budgeting methods to analyze financial information: (1) net present value (NPV), (2) internal rate-of-return (IRR), (3) payback, and (4) accrual accounting rate-of-return (AARR). Both the net present value (NPV) and internal rate-of-return (IRR) methods use discounted cash flows, which we discuss in the next section.