CAPITAL BUDGETING DECISION

The ability to plan and evaluate economically major projects is a part of most large government agencies and engineering firms. Most agencies have guidelines and regulations to evaluate rationally proposed projects with regard to their economic feasibility. Almost all guidelines and regulations require that the benefits of the proposed project exceed the cost of the project. Because corporate investment in projects has serious consequences for the financial viability of a corporation, private-sector projects are often easier to evaluate than their public-sector counterparts. Corporate policies require rational and deliberate analysis of capital budgeting decisions before projects are approved. Corporate investment is different from government investment in major capital projects because corporate entities must also consider the source of funding. In many instances, the ability to finance a project (in lieu of the most economical alternative) determines its feasibility. In some cases, capital projects may be financed through corporate bonds or other vehicles. Invariably, when the project nears realization, financing will depend on borrowed money. The methodof financing must be considered in the corporate capital budgeting decision becausethis factor may determine the viability of the project.

It is important to understand that the economic evaluation of alternatives and the evaluation of alternative financing for a project are key to the viability of that project. Economic evaluation involves developing the cash flows representing the benefits and costs associated with the acquisition and/or operation of the system. The cash flow over the life cycle is often referred to as the economic cash flow. Economic analysis of a program or project should include the financing plan—the cash flow representing the incomes and expenses for funding the project.

1. Basic Concepts in Capital Budgeting

The object of the economic evaluation is to select the most cost-effective alternative that will satisfy the stakeholder requirements. It may be to approve or reject a single project or a family of projects (i.e., a program). Thus, prior to performing the economic analysis, one must identify the alternatives. To analyze the investment under consideration, you need to collect stakeholder requirements and then establish a life cycle. For some agencies and types of projects, regulations govern the life cycle. For instance, most federal and state flood control projects have a life cycle of 50 years. A co-generation plant (a plant that produces steam for a customer and sells excess energy, perhaps as electricity, to another organization) may have a life cycle of 20 years. The life cycle should bear some relationship to the life of the product.

To determine whether a project is feasible, you must compare its rate of return to a minimum attractive rate of return (MARR) or the required rate of return for the project. The MARR should be greater than the rate of return one may obtain with roughly the same risk in another venture. A project should be feasible if its rate of return exceeds the MARR. Obviously, MARR has different implications for publicand private-sector projects.

In economic evaluations, project alternatives are analyzed with respect to their cash flow profiles over n periods in the life cycle. This type of analysis is usually shown in the spreadsheet format and will be referred to as cash flow schedules. The interest period is traditionally, but need not be, in years.

Once money is invested in a project, those funds are no longer available for investment. The term opportunity cost is the return that could have been realized by investing in the next best alternative, if defined, or another opportunity that becomes known after the decision is made. In general, the MARR reflects the opportunity cost of capital, the market interest rates for borrowing and lending, and the risks associated with the investment in the capital project. For public agencies, policies or regulations may specify the MARR.

2. Benefit and Cost Development

For commercial for profit products, the benefit or revenue of a capital project is relatively easy to determine. The basic revenue is what you can sell the product for, the rental income it can produce, the depreciation or other asset available for tax credit, the rental cost to avoid by relocating staff, etc. For the co-generation plant, it is the steam revenue from the primary user, the revenue from the electricity sold to the grid, etc. For an office building, it is the rental avoidance as well as any rental income provided; both may include tax credits.

For public capital projects such as roads, dams, bridges, mental health, etc., the benefits may be harder to ascertain. For a flood control project, the expected benefits are the lack of property loss, lives not being disrupted, public facilities staying open, etc. The social benefits are more difficult to quantify.

The costs, on the other hand, are more easily quantified. Certainly all the capital costs (labor, equipment, materials, supplies, financing, etc.) in addition to the costs to operate and maintain the facility may be calculated. Finally, the most complicated cost may be the amount and type of financing involved. The amount will have a great impact on the cash flow analysis. Depending on the discount rate, the method of debt repayment may make the difference between a viable and a nonviable project.