2.21 The Capital Budgeting Process Summary and Review 

The corporation will/should go through the following steps prior to making a capital allocation decision.

• Identify and collect the relevant data from the field. Include expected changes in every affected functional area of the business.
• Use Free Cash Flow numbers.
• Do not use accounting-type data. Rules are made by people; rules are arbitrary. It is cash that creates value.
• Use incremental numbers only. It is these data upon which we base our decisions.
• Organize your data assiduously. Decide on how many future periods you will project out. Figuring projected EBITDA and Free Cash Flow is not so simple.
• Account for any operating efficiencies or economies of scale that are generated by the investment.
• Expected inflation should be built into the projected cash flow data. The projected data will be discounted using the (weighted average-) cost of capital.
• Financing flows are ignored in arriving at Free Cash Flow; they are part of the discount rate (weighted average-) cost of capital.
• Choose the correct cost of capital. It changes periodically. We observed that small differences in discount rate can matter.
• Consider the competition. What will happen competitively if the firm rejects the project?
• What capital budgeting technique will you choose?
• Are you brave (or foolish?) enough to go against the capital budgeting decision rules based on, potentially subjective, qualitative notions?
• Some companies may choose not to make certain investments for ethical reasons – even though the project may be hugely profitable. These companies will refuse to pollute, for example. “ESG” or Environmental and Social Governance considerations are important today to many corporations.