Capital budgeting is broadly defined as
the process of selecting capital assets
based on the allocation of limited resources
with the anticipation of returns over an
extended period. Today’s capital budgeting
involves management personnel identifying
specific projects for possible acquisition
that align with pre-determined investment
goals and objectives. The most important
criterion is expected return. Comparative
analysis of forecasted returns permits
investors to evaluate the merits of one
project over another and cash flows
generated from a capital project are
fundamental in determining these returns.
Consequently, considerable effort is
expended in evaluating both cash flow before
tax and cash flow after tax using a variety
of investment tools such as payback period,
discounted cash flows, present value, net
present value, and internal rate of return.
Modern capital budgeting theory has
gradually migrated from financial markets
into the real estate field, but not without
modifications. The theory of capital
budgeting rests on a fundamental premise
that the value of a project depends on cost
in relation to future incomes. The issue of
financing does not factor into the equation
in pure capital budgeting models developed
by financial analysts. In fact, asset
managers prefer the screening and selection
of projects without regard to financing.
Texts sometimes reference this technique as
the whole cost approach which facilitates
simplified decision-making based on the
merits of particular projects followed by
the acquisition of the best available
financing to effect the capital
acquisition(s).
The lack of consideration for financing
was also prevalent in the appraisal field.
Appraisers traditionally followed a holistic
approach by concentrating on income analysis
by way of a static snapshot of the property
(capitalizing stabilized net operating
income), or at minimum, analyzing property
in terms of land and building components.
Since the 1960s however, appraisers have
paid closer attention to the division of
equity and debt components in real estate
investments. Direct and yield capitalization
approaches now provide methods for detailed
equity analysis (as separate from financing
issues), either through income rates (direct
capitalization), or yield rates (yield
capitalization).
Real estate theorists are also departing
from traditional capital budgeting processes
given the unique qualities of real estate
investment. While the impact of financing
arrangements may be minimized in non-real
estate capital assets (although the debate
continues based on specific circumstances),
real estate projects are typically linked
directly to financing alternatives. The
success or failure of a venture often hinges
on favorable debt servicing terms. In fact,
leverage is a focal point of conversation in
most real estate acquisitions and
contributes directly to the yield realized
on the equity investment in real estate
capital projects. As a result, modern
comparative tools understandably favour the
separation of equity and debt components.
Further, real estate analysts show a
distinct preference for after tax
perspectives given inherent tax sheltering
mechanisms built into real estate
investments.
Capital budgeting methodologies, for
real estate purposes, are focused on the
discounted cash flow analysis model or
simply the cash flow model. This model
recognizes the inherent contribution of
financing and leverage within
decision-making strategies and proponents
point to the advantage of including timely
real estate debt costs in the proper
evaluation of any project. The fact that
capital budgeting techniques differ between
real estate and other disciplines should not
be overly emphasized. The difference of
opinion merely reflects the unique qualities
of income property ownership. Real estate
investment analysis is acquiring a distinct
status in the realm of capital budgeting.
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