The 5 Principles of Capital Budgeting
- Graziano Stefanelli
- Aug 27, 2022
- 1 min read
Let’s see which are the 5 PRINCIPLES of CAPITAL BUDGETING process, which consists in finding and analyzing CAPITAL PROJECTS – mid-long and long term company’s investments.
➊ Decisions are based on CASH FLOWS, not accounting income nor any profit & loss model: so “profitability” in strict sense is not considered, since “revenues minus costs” is related to accounting methods and time competence recognitions
➋ Cash flows are based on OPPORTUNITY COSTS, which are generated by the project itself (for example keeping a machine only for a new item production project: that machine could be sold otherwise); sunk costs (incurred before), on the other hand, are not taken into account
➌ The analysis is made on an AFTER-TAX BASIS: tax effects should always be included in the calculation
➍ FINANCING COSTS are already present in the DISCOUNT RATE, that in turn depends on the company’s cost of capital and which is applied on every cash flow: therefore financing expenditures for the project (interest payments, etc.) are not recognized when calculating the cash flows
➎ TIMING is always important: the simple rule of time value of money always underpins cash going in and out, sooner or later.
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