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Subject 1. Capital Budgeting: Introduction

Capital budgeting is the process of planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one year. Managers analyze projects and decide which ones to include in the capital budget.

  • "Capital" refers to long-term assets.
  • The "budget" is a plan which details projected cash inflows and outflows during a future period.

The typical steps in the capital budgeting process:

  • Generating good investment ideas to consider.
  • Analyzing individual proposals (forecasting cash flows, evaluating profitability, etc.).
  • Planning the capital budget. How does the project fit within the company's overall strategies? What's the timeline and priority?
  • Monitoring and post-auditing. The post-audit is a follow-up of capital budgeting decisions. It is a key element of capital budgeting. By comparing actual results with predicted results and then determining why differences occurred, decision-makers can:

    • Improve forecasts (based on which good capital budgeting decisions can be made). Otherwise, you will have the GIGO (garbage in, garbage out) problem.
    • Improve operations, thus making capital decisions well-implemented.

Project classifications:

  • Replacement projects. There are two types of replacement decisions:

    • Replacement decisions to maintain a business. The issue is twofold: should the existing operations be continued? If yes, should the same processes continue to be used? Maintenance decisions are usually made without detailed analysis.
    • Replacement decisions to reduce costs. Cost reduction projects determine whether to replace serviceable but obsolete equipment. These decisions are discretionary and a detailed analysis is usually required.

    The cash flows from the old asset must be considered in replacement decisions. Specifically, in a replacement project, the cash flows from selling old assets should be used to offset the initial investment outlay. Analysts also need to compare revenue/cost/depreciation before and after the replacement to identify changes in these elements.

  • Expansion projects. Projects concerning expansion into new products, services, or markets involve strategic decisions and explicit forecasts of future demand, and thus require detailed analysis. These projects are more complex than replacement projects.

  • Regulatory, safety and environmental projects. These projects are mandatory investments, and are often non-revenue-producing.

  • Others. Some projects need special considerations beyond traditional capital budgeting analysis (for example, a very risky research project in which cash flows cannot be reliably forecast).

Study notes from a previous year's CFA exam:

1. Capital Budgeting: Introduction