Summary by Brook Robinson
Master of Accountancy Program
University of South Florida, Fall 2001
Capital Budgeting Main Page | Investment Management Main Page
Introduction
Numerous investment decisions are made using various types of capital budgeting techniques. Methods such as return on investment, pay-back period, and currently the most popular, net present value, are among the few capital budgeting techniques used to determine the requirements, profitability and the costs of various projects. The usefulness of capital budgeting is not under question, but the reliability is. Capital budgeting methods require enormous, if not total use of estimates and forecasts. Many investors ask whether it is efficient to rely on figures that are based on previous expenditures and future predictions. The estimates used in capital budgeting must be computed so that the margin of error is small enough to create relevant and reliable numbers for the assessment of various projects.
Part One of Capital Budgeting - Investment requirements
The first part of capital budgeting, after creating the estimates for the project (e.g., construction of a plant), is to consider the possibility of changes in estimates. It is highly probable that the initial estimates will need to be adapted for changes in prices, scheduling impediment due to lack of materials or equipment, and labor problems. Another problem that could prove difficult and detrimental is if new technology or other innovations are not implemented correctly, or in an efficient manner. Problems such as these would cause the estimates to be way off target, which would give investors a false number and potentially lead to an incorrect decision.
Part Two of Capital Budgeting - Projection of revenues
Estimating revenues is another part of capital budgeting that requires heavy forecasts. Revenue estimates, in turn, rely on estimates of the output period, the expected pattern of prices and the estimated life of the assets (e.g., buildings). The pattern of output depends on the total output of the industry, the projected products market share, and the projected output of the given entity. The pattern of prices depends on the production costs; the supply and demand of the product; the chance of setting a premium price because of the products uniqueness and the general price level changes, all of which are estimates. The estimated productive life of the assets (e.g., buildings) depends on the probability that the assets will become obsolete because of changes in product requirements; the chance that a new assets (e.g., buildings) would be needed for reasons such as pollution or the possibility that the location of the assets (buildings) need to be relocated due to vendor changes. These are most of the variables that need to be considered just for the revenue estimates.
Part Three of Capital Budgeting - Projection of costs
The final factor involved in the capital budgeting process deals with the costs of production and other factors that affect revenue. The estimated cost of production entails estimated changes of variable costs, fixed costs, distribution costs and tax rates. Estimated variable costs must also take into account the additional input requirements due to an increase in efficiency; the estimated change in input requirements due to changes in competition, suppliers or governmental regulations; and other estimated input adjustments. The estimated fixed costs have to account for the predicted changes of time patterns related to the production costs.
Accuracy Required
In order to be able to decide on whether or not to embark on an investment project, there needs to be accuracy involved in the determination of the estimates and forecasts. As stated above, one estimate depends on yet many other estimates, but it has to be done in order to get the full picture of the project. Investors depend on these estimates to be reasonably accurate. The author states that the investment requirements, part one of capital budgeting, is more likely to be accurate than the projection of revenues and costs, parts two and three. Another difficulty arising from estimates is the acceptable margin of error. By how much can the true numbers deviate from the projections and still be meaningful? Unfortunately, those are questions that are hard to answer, if not impossible.
Conclusion
Although investors are often skeptical about capital budgeting, it does provide useful insight into the decision making process. The use of estimates in capital budgeting is inevitable because investors are trying to predict the future. The important part of the budgeting techniques is to have the margin of error fall within a range that allows the estimates to be useful for making decisions. In determining the usefulness of capital budgeting, the author concludes by making three points:
1. entities don’t have much of a choice about taking on new projects, but it’s a question of when they will do such;
2. long run estimates are not accurate enough for top management to capitalize on an opportunity; and
3. the belief that although mistakes are bound to occur, it’s most important to catch the errors as early as possible in order to keep the costs as low as possible.
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