Effective capital investment decisions must allocate constrained resources cash to projects that will return a positive cash flow over a time horizon dictated by an owner or by corporate policy. When there are multiple demands for cash for example, a new marketing campaign, geographic expansion plans, a need for additional production capacity, replacement of outdated or high maintenance equipment, each project will be prioritized depending on the cash they generate over a predetermined time frame.
The time frame will play an important role if the company is currently focused on projects that provide prompt returns versus projects which will contribute to future growth. The factors below will influence capital investment decisions:. You want to avoid reaching a capital investment decision subjectively then apply financial metrics in an attempt to rationalize the decision.
As I referred to in a previous discussion, internal politics can play a role in subjective decisions when individuals or groups have a personal interest in certain projects. The capital investment process usually involves the following seven steps:. This decision is not as obvious or as simple as it may seem. There is a lot at stake with a large outlay of capital, and the long-term financial impact may be unknown due to the capital outlay decreasing or increasing over time.
To help reduce the risk involved in capital investment, a process is required to thoughtfully select the best opportunity for the company. The company must first determine its needs by deciding what capital improvements require immediate attention. For example, the company may determine that certain machinery requires replacement before any new buildings are acquired for expansion. Or, the company may determine that the new machinery and building expansion both require immediate attention.
This latter situation would require a company to consider how to choose which investment to pursue first, or whether to pursue both capital investments concurrently. The decision to invest money in capital expenditures may not only be impacted by internal company objectives, but also by external factors.
This has led to uncertainty for United Kingdom UK businesses. Because of this instability, capital spending slowed or remained stagnant immediately following the Brexit vote and has not yet recovered growth momentum. The UK is expected to separate from the EU in Sometimes a company may have enough resources to cover capital investments in many projects.
Many times, however, they only have enough resources to invest in a limited number of opportunities. If this is the situation, the company must evaluate both the time and money needed to acquire each asset. Time allocation considerations can include employee commitments and project set-up requirements.
Fund limitations may result from a lack of capital fundraising, tied-up capital in non-liquid assets, or extensive up-front acquisition costs that extend beyond investment means Table Once the ability to invest has been established, the company needs to establish baseline criteria for alternatives. Alternatives are the options available for investment. For example, if a company needs to purchase new printing equipment, all possible printing equipment options are considered alternatives.
Since there are so many alternative possibilities, a company will need to establish baseline criteria for the investment. Baseline criteria are measurement methods that can help differentiate among alternatives. Common measurement methods include the payback method, accounting rate of return, net present value, or internal rate of return. To evaluate alternatives, businesses will use the measurement methods to compare outcomes. The outcomes will not only be compared against other alternatives, but also against a predetermined rate of return on the investment or minimum expectation established for each project consideration.
The rate of return concept is discussed in more detail in Balanced Scorecard and Other Performance Measures. A company may use experience or industry standards to predetermine factors used to evaluate alternatives.
Alternatives will first be evaluated against the predetermined criteria for that investment opportunity, in a screening decision. The screening decision allows companies to remove alternatives that would be less desirable to pursue given their inability to meet basic standards. For example, if there were three different printing equipment options and a minimum return had been established, any printers that did not meet that minimum return requirement would be removed from consideration.
If one or more of the alternatives meets or exceeds the minimum expectations, a preference decision is considered. A preference decision compares potential projects that meet screening decision criteria and will rank the alternatives in order of importance, feasibility, or desirability to differentiate among alternatives.
Once the company determines the rank order, it is able to make a decision on the best avenue to pursue Figure When making the final decision, all financial and non-financial factors are deliberated. Sometimes a company makes capital decisions due to outside pressures or unforeseen circumstances. Volkswagen used capital budgeting procedures to allocate funds for buying back the improperly manufactured cars and paying any legal claims or penalties.
Other companies might take other approaches, but an unethical action that results in lawsuits and fines often requires an adjustment to the capital decision-making process.
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The corporate manager could easily be forgiven for assuming that capital budgeting is primarily concerned with the selection of an appropriate evaluation technique. Most texts on the subject are devoted almost entirely to such topics as comparisons of evaluation techniques, determining hurdle rates of return and incorporating risk into the equations. Only a few writers have suggested that this emphasis is misplaced.
This article places evaluation within the whole capital investment process from the conception of an investment opportunity to its completion. It also considers the total investment programme and how it relates to organisational planning and control systems. Dobbins, R. Report bugs here. Please share your general feedback. You can join in the discussion by joining the community or logging in here.
You can also find out more about Emerald Engage. Visit emeraldpublishing. As I discuss each step I will post user friendly templates on our website that can help improve your capital investment decision process. Your email address will not be published. The capital investment process usually involves the following seven steps: Project identification Project definition Analyze the project benefits financial and non-financial Approve capital investment Implement the project Project management Audit and report actual benefits versus assumptions I will dig deeper into each of these steps in my future discussions.
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