Any financial news you come across indicate capital investment decisions are very critical for any growing firm that wants to stay in business and have an edge over the rest. Remember that planning for capital investments is not an easy affair and involves people both within and outside a company. Therefore, the process must be handled carefully as any mistakes made can be expensive and sometimes irreversible. The technicality and nature of capital decisions vary depending on the size of the firm.
Lower cadre managers are free to make decisions that do not exceed the capital budget while more complex decisions are left higher cadre managers. Capital budgeting is looked at in the financial market as cost benefit analysis where at the margin benefits from improved decision making should exceed the cost of capital budgeting strategies.
Relevant cash flows in this kind of budgeting depend on the future of cash flows and benefits which include income and non cash expenses. In order to determine the relevant cash flows, it is important to have high level professional skills in order to made sober judgments.
There are two types of outputs in relevant cash flows namely: cash and cash inflows. It is quite easy to determine cash outflows which might include the initial capital and the cost o installation of machinery and plant. You may also wish to include reversal of initial capital repayment once the project has been completed. Cash inflows on the other hand are quite complex. You determine them by adding depreciation to profits after tax annually. The remaining value of an asset and the recovery of working capital may be included at the completion of the project.
You may wish to break down total risk into two parts namely: systematic risk and unsystematic risk where systematic risk is a part of risk related to the market. On the other hand an unsystematic risk is more of non market risk which can easily be diversified away. As diversified investor, you can only demand a risk premium for taking systematic risk and not unsystematic risk. When investors are financing a project, then they are diversified and it can be improper to include unsystematic risk factor to determine expected returns for the project.
Forecasting the inflation to add its effect in cash flow and discount rate is another important consideration in capital budgeting. It is important to have accuracy of estimation when forecasting inflation since if the inflation is higher than projected, the profitability of investments will also be low. As seen in most financial news, inflation shifts wealth from the taxpayer to the state. When it is higher the firm’s real taxes will also be higher as it reduces the depreciation value of tax shelter.