In sum, the capital budgeting process is the tool by which a company administers its investment opportunities in additional fixed assets by evaluating the cash inflows and outflows of such opportunities. Once such opportunities have been identified or selected, management is then tasked with evaluating whether or not the project is desirable.
Depending on the business, the competitive environment and industry forces, companies will certainly have some unique desirability criteria. As noted earlier, it's very crucial to remember that the capital budgeting process involves two sets of decisions, investment decisions and financial decisions; given the unique business and market environments that exist at the time, each decision may not initially be seen as worthwhile individually, but could be worthwhile if both were to be undertaken.
Consider an example involving the coffee chain Starbucks. On Nov. 14, 2012, Starbucks announced its intent to acquire Teavana, a high-end specialty retailer of tea, for $620 million. The offer price for Teavana represented a 50% premium over the then market value of Teavana. Based on the acquisition price, Starbucks would paying over 36 times earnings for Teavana. Looking at this capital investment today, one can suggest that the financial decision – paying $620 million for a company that generated $167 and $18 million in sales and profits in 2011 – was not a desirable one for Starbucks.
On the other hand, from an investment perspective, Starbucks is paying $620 million for ownership of a fast-growing, leading tea retailer. Teavana gives Starbucks direct access to the fast-growing underpenetrated tea market. In addition, Teavana instantly gives Starbucks approximately 200 high-traffic retail locations and, more importantly, a very visible, high-quality tea brand to complement its coffee offerings. Had Starbucks merely evaluated Teavana from a purely financial perspective, the decision would have ignored that highly-valuable benefit of combining the most well-known coffee brand with the highest-quality tea brand.
Generally speaking however, businesses will consider the following questions when evaluating whether or not a project is desirable and should be pursued.
What Will the Project Cost?
This is the first and most basic question a company must answer before pursuing a project. Identifying the cost, which includes the actual purchase price of the assets along with any future investment costs, determines whether or not the business can afford to take on such a project.
How Long Will It Take to Re-coup the Investment?
Once the costs have been identified, management must determine the cash return on that investment. An affordable project that has little chance of recouping the initial investment, in a reasonable period of time, would likely be rejected unless there were some unique strategic decisions involved. For Starbucks, it is counting on the fact that when Teavana's brand is matched with Starbucks vast distribution network, the rapid growth in sales of tea and tea related projects will deliver tremendous cash flows to Starbucks. Of course, there is no guarantee that management's forecast will prove accurate or correct; nevertheless, forecasting future cash inflows and outflows are a vital exercise in the capital budgeting process.
Mutually Exclusive or Independent?
All investment projects are considered to be mutually exclusive or independent. An independent project is one where the decision to accept or reject the project has no effect on any other projects being considered by the company. The cash flows of an independent project have no effect on the cash flows of other projects or divisions of the business. For example the decision to replace a company's computer system would be considered independent of a decision to build a new factory.
A mutually-exclusive project is one where acceptance of such a project will have an effect on the acceptance of another project. In mutually exclusive projects, the cash flows of one project can have an impact on the cash flows of another. Most business investment decisions fall into this category. Starbucks decision to buy Teavana will most certainly have a profound effect on the future cash flows of the coffee business as well as influence the decision making process of other future projects undertaken by Starbucks.
Capital Budgeting: Capital Budgeting Decision Tools
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