Capital Budgeting


Capital Budgeting

Capital budgeting is about how to budget and spend cash for the big-ticket items on the project. Spending cash creates cash flow. The cash flow statement is one of the important tracking tools for the capital budget. Capital budgeting is closely related to the concept of discounted cash flow (DCF), a methodology to assign risk (that is, a discount) to cash flows that will occur in the future. In this section we address the capital budgeting per se and address its close cousin, DCF, in the next section.

Capital Budgeting for Projects

Capital budgets refer to those project budgets for which cash is paid out now, in the present during the project execution, but for which the expense will be recognized in the future when the item is put into use. The principle at work is "alignment": use and the cost of use should align in the same period. Expensing could begin during project execution if the capital purchase is to be used for the project itself, or expensing could be deferred until the capital item is to be used for operations after project completion. Expensing the capital item "relieves" the balance sheet amount for the item each time an expense is recorded on the expense statement. When the balance sheet amount is fully relieved (that is, the amount on the balance sheet is $0), then expensing ends. Table 5-4 provides an example. The controller will make the decision about what project items to make capital purchases and when the expensing of those items will begin.

Table 5-4: Expensing the Balance Sheet

Item

Year 0

Year 1

Year 2

Year 3

Year 4

Balance sheet capital employed, crane with truck

$500,000

$375,000

$250,000

$125,000

$0

Depreciation to the P&L statement, straight line method*

$0

$125,000 = $500,000/4

$125,000 = $500,000/4

$125,000 = $500,000/4

$125,000 $500,000/4

Balance sheet capital employed, software license

$500,000

$300,000

$150,000

$50,000

$0

Depreciation to the P&L statement, sum of years method (4 + 3 + 2 + 1 = 10) [*]

$0

$200,000 = (4/10) * $500,000

$150,000 = (3/10) * $500,000

$100,000 = (2/10) * $500,000

$50,000 = (1/10) * $500,000

[*]Notes: In the straight line method, an equal amount is expensed to the P&L each period, In the sum of years method, the number of years is added cumulatively to find the denominator; the numerator is the "year number."

So far, our discussion has been about paying cash for a capital item. It is possible to lease a capital item and thereby create a "capital lease." A capital lease shows up on the balance sheet as a liability, just like a purchased item would show as an asset. The lease payments are expensed, thereby relieving the balance sheet liability. There are several tests the controller applies to determine if a lease is a capital lease or an "operating lease." The latter is expensed just like a rental item or an item bought on credit. The controller is the ultimate decision maker on whether a lease is a capital lease or an operating lease.

Capital Structure and Projects

Going back to the discussion of the balance sheet in Chapter 3, we know that assets on the left side are "paid for" or "financed" by liabilities on the right side. Owners, shareholders, debt holders, and suppliers are the creditors of the business. The relative weight of debt and owner capital paid in is called the "capital structure" of the company. Generally speaking, the long-term debt (like capital leases, notes and bonds, and capital paid in for stock or partnership) finances the long-term capital purchases; short-term debt (such as accounts payable to suppliers) finances the short-term assets (like accounts receivables).

For project managers, the importance of the capital structure is this: there is a "cost of capital" that is passed along to the project. For the most part, the cost of capital is not a real expense that shows up on an expense statement, but it is an "opportunity cost" that creates competition for capital. If the project loses out in the capital competition, the project is starved of the resources it needs or the project is never approved in the first place.

Opportunity Cost for Projects

The opportunity cost works as follows for projects: If a company has investment dollars that can be made available to projects, which projects should get what amounts? The decision is usually made on the basis of benefit returns to the company. The ratios in play are the ROI (return on investment), the net present value (NPV), and the economic value add (EVA). We will define these for the project manager and demonstrate their application to projects in subsequent paragraphs.

Suffice it to say, benefit returns are risky because they are earned in the future. Therefore, benefit returns must be risk adjusted before they are plugged into the formula. The opportunity cost is then the difference in returns, after risk adjustment, between one project opportunity and the next most favorable opportunity that is competing for the same capital.

The role of project managers in the capital competition is twofold: provide risk management so that the returns are maximized to the extent possible, and manage capital budgets to minimize capital expenditures. Those two activities will maximize the returns and minimize the opportunity cost of the project.

Consider an example project situation as shown in Table 5-5. There we see two projects, each with different demands on capital and expense, but each with an equal face-value opportunity for net benefits, $175,000. If not for considering the confidence of obtaining the returns, there is no opportunity cost between these two projects. However, our confidence in one project's return is higher than the other. On a risk-adjusted basis, there is a "cost" of selecting the more risky project. The cost we speak of is an opportunity cost of picking one over the other. To ensure the selection of the more favorable project, the decision policy must embrace the concept of opportunity cost. The objective of the project team is to make the risk factors as favorable as possible in order to create the greatest competitive advantage for the project.

Table 5-5: Opportunity Cost for Projects

Project Manager's Responsibility

Project Sponsor's Responsibility

Capital Employed

Expenses

Confidence in Capital and Expense

Benefits Over Three Years

Confidence in Benefits

Net Risk Adjusted Return

Project A

$350,000 (depreciate over three years)

$125,000 (one year)

80%

$650,000 cumulative

75%

Compared to B higher cost risk, same benefit risk

Project B

$50,000

$300,000

90%

$525,000

75%

Compared to A lower cost risk, same benefit risk

Project A Benefit - Cost = $650 - $475 = $175

Project B Benefit - Cost = $525 - $350 = $175

Opportunity Cost A = Project A - Project B higher risk

Opportunity Cost B = -Project A + Project B lower risk

Without considering risk, the opportunity cost of Project A vs. Project B is $0.