Capital budgeting is the system used by businesses to allocate funds to projects and investments that create additional value for the company (Hickman, Byrd, & McPherson, 2013). Value is determined by weighing the costs of an investment against the potential revenue. An investment that creates more value than the cost is said to be a sound investment decision (Hickman, Byrd, & McPherson, 2013). You have spoken about four quantitative methods used in determining if a project is worthy of investment: the payback method, the rate of return method, net present value, and the internal rate of return (gordonhensley, 2012). However, there are other factors that managers should consider before giving an investment project the green light.
Factors used in capital budgeting can be numeric (quantitative) or non-numeric (qualitative). The four methods to determine if an investment makes sense represent quantitative factors in deciding capital budgets. Another numeric consideration should be the tax shield a capital expense provides a company. A capital purchase reduces net income which in turn reduces the tax liability of a company (Wainwright, 2012). Additionally, the depreciation of the asset further reduces tax liability over the life of the capital asset. Let’s take a look at an example to demonstrate the tax shield effect on capital budgeting.
|15 years||Taxes w/out depreciation||$1,200.00|
|Annual Depreciation||Taxes w/depreciation||$780.00|
|Tax Rate||Cash flow savings||$420.00|
Looking at the numbers, the company would pay $1,200 in taxes if their revenue increases by $4,000 without any means to reduce tax liabilities. However, the depreciation of a capital asset reduces the revenue providing protection on the taxation of $1,400. This provides the company with an increase in cash flow of $420 since the company will not pay 30% taxes on $1,400 of the $4,000 in revenue. Other considerations in capital budgeting involve qualitative factors.
One such qualitative factor is human capital. According to Youssef (2015), human capital refers to knowledge skills, abilities, and other qualitative benefits an organization receives from its workforce. With this factor, the financial bottom line should not matter. If a company does not have the personnel to transform an investment intvalue-creatingting venture, the venture will likely end in failure and any capital spent pursuing that venture will end up being a sunk cost, that is, a cost that cannot be recovered through business operations (Hickman, Byrd, & McPherson, 2013). Sunk costs do not provide operational benefits as they do not generate revenue. A failed venture no longer generates revenue meaning all costs associated with the venture will become sunk costs.
Thank you again for having me speak on your program today. May your capital live long and prosper.
gordonhensley. (2012). Capital budgeting lecture. [Video file]. Retrieved from https://www.youtube.com/watch?v=TrKVj_wLgUc
Hickman, K. A., Byrd, J. W., & McPherson, M. (2013). Essentials of finance [Electronic version]. Retrieved from https://content.ashford.edu/
Wainwright, S. K. (Ed.) (2012). Principles of accounting: Volume II [Electronic version]. Retrieved from https://content.ashford.edu/
Youssef, C. (2015). Human resource management (2nd ed.). Retrieved from https://ashford.content.edu