Introduction
In simple terms, capital budgeting refers to the process of making decisions of long-term investments. This decision making process allows firms to measure viability of long-term investments and decide whether they should be undertaken.
Capital Budgeting
Institute of Management of Accountants (2009) defines two kinds of investments made by firms: capital and current. Capital investments are long term and they require current cash investments with benefits anticipated in the future. Examples include spending money on new buildings and equipment or their replacement. On the other hand, current investments are short term and include such items as salaries, administrative expenses or buying of raw materials. The two kinds of investments are recorded in the capital budget and current budget respectively.
Capital Budgeting Applications
Capital expenditures are categorized differently for purposes of decision-making and analysis. The categories include expansion projects, replacement, mandatory, and other projects. Different schemes are used in classification, but always, it is an organizational objectives and strategies that influence the criteria for evaluation of capital investments.
Notably, there are two important dimensions in capital budgeting: project and time. In the project dimension, decisions on operational budgeting dwell on activities in the short-term period. Conversely, decisions dealing with capital budgeting focus on projects covering several accounting periods. Putting time into consideration, its important to note that even though investment decisions with immediate returns are certainly essential and more appealing, decisions about long-term investments also need to be carefully studied in order to maintain long-term profitability.
Capital Budgeting Stages
Capital budgeting projects have logically arranged activities. However, these stages might vary in name, but they cover identification, investigation, evaluation, selection, financing and lastly, implementation and control. The names of the stages are clear of what goes on in each of the stages.
Incremental Cash Flows
A firm’s cash position is very important and this creates the need to predetermine future cash flows. Capital budgeting therefore places a lot of importance on maintaining a healthy cash flow as these investments affect the firm’s cash position in the current or future times. Cash outflows reduce the amount of cash available for use; while cash inflows increase it. The different types of cash flows are initiation, operation, and disposal cash flows. As the names suggest, they occur during times of initiation, operation and disposal of projects and are determined by different aspects.
The cost of the acquired asset, additional expenses, change in total working capital, proceeds from old asset sale and tax effect on sale of the asset determine the cash flow at the beginning of a project. Change in operating finances and expenses, change in tax charges and other tax effects determine cash flows during the operating period. Lastly, value of disposed assets, tax effect on asset disposal and increase or decrease in total working capital determines cash flow during the disposal stage of the project.
Considerations of Income Tax
Capital investments result in cash flows with different tax effects. In some cases, net cash flows in a project can reduce considerably to a level of influencing their attractiveness. According to Institute of Management Accountants (2009), most of the tax rules for financial statement preparation under Generally Accepted Accounting Principles (GAAP) apply to cash flows coming from projects with capital investments. However, there are special rules for capital investments. Rules touching on depreciation are determined by the allowable depreciation amount, the period for depression and the pattern of depreciation. Nonetheless, determining tax for depreciable assets can at times be complicated. Income generating assets have estimated lifespan and therefore depreciate over the period for purposes of accounting. Nevertheless, obsolescence can come at any time, for instance, when a better machine becomes available in the market.
Overview of Depreciation Methods
Depreciation amount allowable for assets is calculated by first determining the depreciable basis for the particular asset. This simply refers to the amount that can be written off for taxation reasons over a given period. Normally, the amount allowable includes original asset cost and accompanying capitalized expenditures like transportation and installation of a machine. Three methods are employed in determining capital investments in depreciation period. They include tax law, which stipulates allowable life, taxpayer who approximates useful life or lastly, authorities, which approximates useful life.
Further, there are different depreciation patterns used. First is straight-line depreciation, where expenses are allocated equally over an asset life. Each year is allocated an equal depreciation amount. Accelerated depreciation is where capital investments are written off faster than in the previous method. Sum-of-the-years-digits is a form of accelerated depreciation where much of the depreciable value of the asset is written off in the early years. Another example is the declining balance depreciation where the book value of the asset is reduced by a similar percentage every year. However, unlike in the other methods, depreciation expense is stopped when the cost minus salvage value has been depreciated.
In brief, depreciation expense affects income taxes paid by a firm for a certain period. Tax liability decreases due to depreciation charge. This is called depreciation tax shield and is equal to the amount of depreciation multiplied by existent tax rate. In addition, depreciation deductions are non-cash costs, which reduce taxable income and the amount of tax paid.