Six Basic Capital Budgeting Questions

Finance One of the biggest differences between new capital projects and renewal/replacement projects is that the variables are less known. The cash flow for the next few years is subject to a higher degree of uncertainty, but so too is the risk profile for the project. The latter is especially important when the project is in an entirely new business, and the firm has very little concrete information to go on.

The reality is that for renewal projects, there is a lot more certainty about everything, and that makes a difference in the capital budgeting process because the numbers are more reliable and the company knows that the discount rate appropriately reflects the risk associated with that project. It must be cautioned, however, to remember that incremental cash flows only should be incorporated into the calculation for renewal projects, not money that has already been committed to the project (Investopedia, 2016).

Interest charges are not included in the cash flows for the project because interest represents a financing charge. Financing charges are reflected in the discount rate, which includes the cost of capital, which itself includes the cost of debt. Because of the Modigliani-Miller principle, financing charges are not included as cash flows as the type of financing should ultimately not matter (Investopedia, 2016). 3 There are several different types of risk that affect operations of corporations. There is strategic risk, which relates to operating in that industry at that moment in time.

An example would be whatever risk was inherent in making PDAs when the smartphone was invented and killed the category. There is also firm-specific risk that relates more to the company than the industry, such as the reality that firms with one product face greater risk than firms that have a more diversified portfolio. There are legal risks relating to any number of laws, and political risks that relate to the influence of government and government action over business. Political risk can vary dramatically across different countries (Griffin, 2016).

There are different financial risks, including credit risk (related to extending credit to customers), foreign exchange rate risk (when dealing in other currencies) and interest rate risk. There might be reputation risk, especially for companies that are just starting to build their brand. The value of that brand is sometimes at risk if the company has a problem with a key product, or if the company itself faces scandal. Lastly, there are operational risks, related to the ongoing conduct of business.

Some companies are inherently in riskier industries (ocean shipping is riskier than accounting, for example). And everybody deals with risks like war or natural disasters, though these vary from place to place. 4. Working capital is recovered at the end of a project in the sense that whatever working capital exists will be put back into the company at the end of the project. Working capital has to be taken into account in capital budgeting because of the time value of money.

For example, if a firm puts $100 of working capital into a project and three years from now gets $100 back, the value of the working capital returned is lower in terms of present value than the initial working capital, and that must be taken into account. 5. Real option valuation is the application of options valuation techniques to the capital budgeting decision. In many cases, a project will have some sort of option embedded, and that option has value.

For example, if you expand overseas with a partner, and have an option to buy the partner out at some future date, that option has some value today, and makes the partnership potentially more value than if there was no concrete buyout option. Options valuation techniques take into account things like the volatility of the asset's value and the cost of exercising the option in order to determine what that option.