Capital Budgeting If/How Businesses should invest their capital
Capital Budgeting refers to the use of debt and equity capital. But because debt and equity can be raised (or paid back), this is not a traditional “fixed” budget. Cash $$$ Debt (Liabilities) $$$$ When debt and/or equity money – or retained earnings from profit – flows into the company, its cash balance increases. $$$$ Equity Is this a good thing?
Unfortunately, the Debt and Equity Capital are not free. Where’s my 7% interest you owe me??? Creditors (banks) who hold the business’s debt demand interest and repayment. And equity holders demand an even higher rate of return on their investment! I don’t need YOU to put my money in a bank ! I can do that myself without you !!! Just because you don’t guarantee me interest doesn’t mean that my money is free !!! And I expect at least 12% on my investment !!! Cash $$$ Debt (Liabilities) Cash just sitting in the bank will not earn enough interest to satisfy creditors and investors. + 4% Equity So the ANSWER is that bringing in new money – or even keeping old money – is only good if it is profitable enough to pay back creditors and investors !
To pay back creditors and investors, cash has to be invested in something more profitable ! Merchandising business might want to invest in inventory. Financial businesses might put the cash into financial investments. But manufacturing businesses will invest the money in fixed assets to grow their business. Cash $$$ Debt (Liabilities) $$$ Inventory $$$ Profit from Sales Inventory $$$ Profit from Investment Financial investment $$$ Investments Equity Fixed Assets (Property, Plant & Equipment) I don’t want “real” businesses doing financial investments ! I can do those by myself ! $$$ Real Investment $$$ Profit from Investment
Where to Apply Capital Budgeting Techniques Capital Budgeting techniques could apply to the type of long-term investment decisions made by both financial and manufacturing businesses. But, traditionally, they are only applied to manufacturing businesses. Capital Budgeting is a term normally applied to Manufacturing Businesses considering expanding their business.
So this raises the question….. QUESTION: How / When should manufacturing businesses invest the money in fixed assets to grow their business ??? Cash $$$ Debt (Liabilities) Interest and debt repayment Equity Fixed Assets (Property, Plant & Equipment) $$$ Real Investment $$$ Profit from Investment Dividends to equity investors ANSWER: the investment(s) have to be profitable and safe enough to make creditors and investors happy !
The Time Value of Money Exactly how we discount risky future cash flows is the subject of the next slide presentation.