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Capital Budgeting Essay Sample

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Introduction

An organization’s success is largely a reflection of the profit earned to its shareholders or its owners. This includes different managerial activities that are involved in the planning and regulating the firm’s financial resources. Financial management is concerned with the decisions involving the financing, dividend and investment. There are many objectives or goals that a firm strives. Increasing the market value of the firm to its shareholders and the owners is the most widely accepted objective for the owners.

This phenomenon is termed as shareholder wealth maximization. The financing management includes the decision concerning the various sources of money, the allocation of fund and last but not the least the distribution of funds to the various sectors of an organization. The future of a company depends on its ability to generate more money that comprises of an enhanced cash flow and attracting more investments from the stakeholders. Each of the above said work is accomplished by the virtue of capital budgeting. In today’s world, all the businesses look for any opportunity that will help multiplying the shareholders value. Capital management ensures that the firm takes suitable investment opportunities that will yield positive results and have good potential for return in future.

Capital budgeting – an overview

Capital budgeting is a process that is used to ascertain whether a firm’s investments or the projects undertaken would be worth more to the business with respect to their cost perspective. The process of allocating budget to any investment opportunity or a project is very crucial, as they cannot be easily reversed once they are implemented (Peterson and Fabozzi, 2002).

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It is imperative for the managers to adopt the sound capital budgeting technique for future benefits, needless to mention that this method is helpful to safeguard company’s funds from any loss as well. Funds are invested in both long term and short-term assets. Capital budgeting primarily concerns the investment in any long-term project or an asset. The asset can be tangible and or intangible item. Tangible items include property, setting up a new factory or plant or any equipment. Non tangible or intangible items  includes investment in a new technology,  processes through which an advanced software and products are created, patents, trademarks, various researches, designs, developments and testing are  also considered as an intangible asset. Capital investments can be differentiated from the recurrent expenditure. The capital investment projects are in general large and their profits or the cash flow spreads over many years (Baker and English, 2011).

The projects are much long lived as well. The return on these investments has an effect on the future cash flow to the company. They are thus the decisive factor regarding the future investment by the stakeholders and the risk associated with the cash flow. Firms should take up the project that has a good potential to enhance the cash flow and would have great influence on the business over a period.

The capital budgeting processes plays an important and a critical role in shaping up the business and are related to the firm’s success or failure, to an extent. It measures the performance of the firm and builds the standard and parameter to gauge and analyze any investment opportunities with respect to the market (Baker and English, 2011).

Businesses aim to enhance the wealth or aspire to increase the profit of the owners and the stakeholders. In order for this, the firm should take up all possible projects that will add value to the company. This whole process is accomplished by capital budgeting. It decides the financial desirability of the project (Garcia, 2009).

It can also be described as the process, which distinguishes a positive project with the negative one. Here the term positive and negative refers to those projects that will be of utmost interest to the stakeholders and its owners. The project, which has the capacity to increase the cash flow to the company, is of tremendous interest to the owners and the stakeholders. In the capital budgeting process, the goal of the shareholder is given the utmost importance.

Capital budgeting is the decision taken before allocating funds to any investment project

The decision taken holds critical to the company as the project will affect the cash flow and the future investment by the stakeholders. This is vital for the organization’s future, longevity and reputation in the market. In the capital budgeting, strategic processing or strategic planning can be considered as the reflection of the whole framework and functioning of the firm (Garcia, 2009).

The identification of a sound proposed capital expenditure and an investment project is of utmost importance. The company should make sure that all the potential investment projects and proposals are thoroughly and effectively studied and decided upon. There should be no biasness while choosing the project, does not matter how much lucrative the project appears. The best of the investment project should be selected, tested and implemented.

The management should be open to any idea or any suggestion coming from outside or inside the firm. The projects are first studied and analyzed by the analysts based on the manager’s expertise, experience and assumption. It is then passed over to the management for further consideration. The projects are then rejected or accepted based on the recommendation and suggestions by the analyst.

There are several stages in the process of capital budgeting

Strategic planning is the first and the foremost step towards the capital budgeting process. The corporate goal is converted into the desired policies, necessary directions that specify the tactical areas of business development towards achieving the goal. In a nutshell, a firm’s goal and aim is encapsulated in the company’s strategic planning. The most important aspect of the capital budgeting process is the generation and choosing the suitable investment project (Graham, Smart and Megginson, 2010).

The project should be in tandem with the company’s goal, visions and long-term plans. The investment opportunity and the strategic planning of an organization go hand in hand. There are again some investments, which are mandatory in nature like the safety requirements, the health measures. Others are discretionary and are taken up in accordance with the suitable growth opportunities, competition in the market, cost-cutting measures and so on. These type of capital budgeting represents the strategic plan of the firm and can be changed or modulated as per the investment opportunity. In some firms, the research and development unit identifies and creates new and attractive investment opportunities (Peterson and Fabozzi, 2002).

The management’s job is to choose the investment project well suited for the company by screening and analyzing the facts and figures of the same. The investment opportunities are subjected to extensive financial screenings and appraisal to ascertain if it would be worth taking the project and if it can add value to the firm. This stage is termed as the qualitative analysis, project analysis or financial and economic appraisal phase. This phase predicts the future cash flow; the possible bottleneck associated with the cash flow, suggests an alternate solution in case of any problem and prepares estimates of the project’s net present value. It takes in to account the forecasting techniques, the evaluation methods, risk analysis and other programming techniques.

The application of a particular type of project requires some experience and knowledge. For example- asset expansion projects, international investments require a particular expertise to accomplish and to exercise it. The result from the project analysis phase dictates and guides the project selection or investment decisions. When a project passes the quantitative test, it is further evaluated with respect to the qualitative factors.

The qualitative factors cannot be gauged monetarily but will have an influence overall journey of project completion. For example- the attrition rate and the new hires, the effect of the government’s rules and policies on the companies, the human resource, the labor union, the consumption and the availability of the raw material, possible legal problems with the brand name, impact of the project or the investment on the society are some of the qualitative factors. The management has to study and predict the negativity of these factors on the project and its future benefits.

The management decides a suitable solution for any negative related to the project and suggests a possible solution for the same. In this endeavor a constant monitoring and study is required to ensure that a corrective action is taken, if necessary. Evaluation of the performance of the similar projects from past are also taken into studied.  Last step is the post – implementation audit which aids in the strategic planning and formation. For example, the positives and the negatives of the past project’s result on the cash flow can provide suitable framework and working for the current one (Peterson and Fabozzi, 2002).

Capital budgeting is also helpful in making marketing plans. The time of completion, the investment, the reason for undertaking such project (social, economical or financial reason) can be chalked out with the help of the capital budgeting process. The marketers can ascertain if the company needs to invest more in the sales force or in advertising. Capital budgeting is one of the crucial elements in business. One wrong decision can jeopardize the entire project and can result in wasting huge amount of money, if the investment results in an uneconomic act.

Processes and techniques – application and theory

In a firm where there is a possibility of suggesting many potential investments or projects, choosing the right type and time is a challenge. There are two types of projects generally undertaken which are the independent projects and the mutually exclusive projects. In the independent projects, the cash flow bears no impact on the sanction or disqualifying the project. In the mutually exclusive, project the cost effect on another. Therefore, they cannot be taken up together. The factors influencing the acceptance or rejection of the project is the particular strategy of the firm, the time needed for its completion, other internal factors like human resources and investment or the fund allotted (Graham et al., 2010).

Independent project can also be described as the one that has no relation with the other project being implemented or under investigation. For example- Buying a new Xerox machine and setting up a new factory. The mutually exclusive projects are those where the firm has the option of choosing among the two, for example- Buying Apple PC or Dell.

In a mutually exclusive project, the firm chooses the one that would enhance the money value and thus the cash flow. For example- If the company has to choose between two coffee vending machine with two different installation charges and energy costs. Both the machines might be in a way are contributing to increase the cash flow but the firm has to choose and decide the one which will add more value to the firm. The ranking approach is taken into consideration while deciding the rank from good to bad. The best is then chosen for implementation (Garcia, 2009). 

Capital rationing is also a decisive factor influencing the decision regarding the project or to ascertain whether to go ahead with a particular investment. Capital rationing refers to the restriction on the amount of investment and funds on any wealth-improving project. Firm may be reluctant to add expense as there may be a conflict among the owners and the partnership may be diluting (Garcia, 2009).

Market should support the fund or provide monetary aid to all those projects that will bring prosperity to the company. However, there might be some limitations on the part of the managers in terms of their expertise or using any specialized machinery. In these cases, the projects selection is done on the basis of the desirability and ranking simultaneously (Tajirian, 1997).

For example- a transport company aspires to expand its business in five different cities. It either has the option to choose some routes to all the cities or to some cities or it can choose not to expand the route. In the cases similar to this, the company has to decide the project based on capital rationing. The decision as to which city the transport company has to expand its business in is the decisive factor. This is considered as short run constraint. Once the rationing is lifted and the short run constraints are over, company can go ahead and can hire more resources or can invest in a bigger project.

The Decision Criteria: Net present value is used as a tool for the accept-reject any investment process. If the value of Net Present Value is greater than $0, the firm accepts the project. If the value of Net Present Value is less than $0, the firm rejects the project. In the first case, the firm will earn more return than the cost of the capital. This will increase the market value of the firm and consequently the wealth of its owners.

IRR (Internal rate of Return)

This is also a sophisticated capital budgeting technique. It can be described as compound annual rate of return, the company can expect to earn provided it invests in the project at a given cash inflow.

The Decision Criteria

If the Internal Rate of Return is greater than the cost of capital, the project is accepted. If it is less than the cost of capital, the project is rejected. This ensures that the firm can get at least the expected return. This will add to the market value and consequently the wealth of its owners.

Payback period

Payback Periods are used to measure proposed investments. This process is considered as an unsophisticated method of capital budgeting. Payback period is the amount of time required by a firm to get back or recover the investment that was done initially in a project.

The Decision Criteria

If the payback period is less that the maximum acceptable payback period, the project is accepted else it is rejected. The maximum acceptable payback period is a value that is set by the management. The decision is based on the type of project, expansion, renewal and other qualitative factors existing in the market.

Current trends

The capital budgeting process uses different techniques. Choosing and applying the best method is a challenge. Prior to the year 1980, managers were dependent mainly on the payback and other methods. The Net Present Value (NPV) method was not in practice then. By 1990, the usage of NPV was the maximum. The Internal rate of Return (IRR) method came into practice, but its popularity and usage were not at par with the NPV. Payback was the most popular method 40 years ago. Its use as the primary criteria has fallen drastically by 1980. Companies are still using the payback method as it is easy to calculate and can be modulated according to the managers’ wish, but it is not used as the primary measuring technique. Other methods are also not widely taken into consideration, as the IRR and NPV are giving results that are more accurate especially the NPV method (Brigham and Houston, 2007).

Evaluation and analysis of techniques

In any capital budgeting process, a project is accepted if it is assumed to increase the profit of the firm and thus bring more wealth to its owners or the stakeholders. Usually the Net Present value (NPV), the internal rate of return (IRR), profitability Index (PI) is used for calculating the viability of a particular investment project.

Each of the technique includes the estimation of the costs incurred, savings and the revenue earned (inflow).The tax effect is also considered. It is though difficult and cumbersome to obtain the relevant dataset, but if used and administered in a relevant way, can fetch more revenue to the company.

The net present value method is rather easy to interpret and analyze. This reflects the ways or the measure to transform the project into wealth, if it is accepted. The net present value has some drawbacks as well. It requires specific expertise to use and solve it. A sound knowledge of finance is also required to implement it. Any wrong calculation in the net present value may upset the entire project if there is capital rationing in the firm. Internal Rate of Return is the rate of return that a project generates.

The Internal Rate of Return is comparatively easy to generate. The acceptance criteria though remain the same- profit factor of the stakeholders. The drawback lies in its usage. It requires a financial calculator to interpret. There are chances that in a particular project there are no IRR, or there are multiple IRRs. Probability Index (PI) is relatively easy to calculate and interpret the result.

It shows the chances of receiving the amount of dollars per dollar invested. In those cases when there is capital rationing in the firm, the Probability Index technique is used and implemented. The drawback with the Probability Index technique is that it cannot be used if initially the money invested is from the savings or the revenue generated. Probability Index cannot be used straightforwardly if there are mutually exclusive projects.

The strength of the payback period is its ease of usage, used by large firms to evaluate small projects. It is considered as a measure of risk exposure, many firms adopt this technique to help take other decisions. It also depicts the time value of money. The drawback of this technique is that it cannot be used for wealth maximization purpose. It only tells the maximum acceptable time to get back or recover the initial investment. It does not completely consider the time factor while deciding the value of money (Capital Budgeting Techniques, 2009).

The capital budgeting process may provide some acceptance or rejection decisions in the independent projects. The problem arises with the mutually exclusive projects. There are chances of conflict arising while deciding between the mutually exclusive projects.

The Net Present Value is always considered while arriving at any conclusion in cases of any conflict. The Net Present Value is more stable, conservative and gives results that are more realistic. The Pay back method is also used but in more complicated situations Net Present value can be used in almost circumstances and is considered superior to even internal rate of return.

Inferences

The whole theory and the structure of the capital budgeting is based upon two approaches-Net Present Value (NPV) and Internal Rate of Return (IRR) on a large basis. The NPV is a better method than the IRR in many ways. The NPV yields more realistic and positive result. Some calculations give more than one IRR that makes it more difficult to understand and interpret. Practically, the financial decision makers consider the IRR a better alternative.

They are more interested in understanding and measuring the rate of return than the actual dollar return. The business people find the NPV less interesting and lucrative, as it does not measure the profit based on the amount invested. There are many techniques and tools available for correcting the loopholes of the IRR technique. The financial business decision makers find it easier and comfortable to use the IRR technique. The IRR expresses the interest rate, profitability and so on are expressed as annual rate of return. 

Conclusion

Capital budgeting is an important element in business. Capital budgeting can be considered as a tool used to understand and make correct estimate of relevant cash flow associated with proposed capital expenditure. The techniques are used for choosing the right investment plan. Decision on investments that take more time to mature should be based on the returns on that investment. The success of a firm is dependent on the kind of investment projects undertaken by the managers. The investment done can generate more revenue and add value to the firm.

It is used in marketing, operations, accounting and so on. For example, the marketers can evaluate if they want to invest more in advertising or in sales force. A firm can lose large amount of money if the investment turns wrong. Decisions regarding which project to invest in, the expected value of return and the time to mature can be calculated and predicted. The need is a thorough understanding and the usage of the techniques involved.

The time of completion, the investment, the reason for undertaking a project (social, economical or financial reason) can be chalked out with the help of the capital budgeting process. Capital budgeting is one of the crucial elements in business. One wrong decision can jeopardize the entire project and can result in wasting huge amount of money, if the investment results in an uneconomic act.

References

  1. Baker, H.K. and English, P. (2011). Capital budgeting valuation: financial analysis for today’s investment projects. John Wiley & Sons.
  2. Brigham, E.F. and Houston, J.F. (2007). Fundamentals of financial management. Thomson Learning.
  3. Capital budgeting techniques. (2009). Independent and mutually exclusive projects. Retrieved on Aug 23 2012 from http://www.capitalbudgetingtechniques.com/independent-and-mutually-exclusive-projects/
  4. Garcia, N. (2009). Capital budgeting. Retrieved on Aug 21 2012 from http://www.csun.edu/~jpd45767/502/7%20-%20Capital%20Budgeting.pdf
  5. Graham, J., Smart, S.B., and Megginson, W. (2010). Corporate finance: linking theory to what companies do. Cengage Learning.
  6. Peterson, P.P. and Fabozzi, F.J. (2002). Capital budgeting – theory and practice. John Wiley & Sons.
  7. Tajirian, A. (1997). The capital budgeting process. Retrieved on 22 Aug 2012 from http://www.morevalue.com/i-reader/ftp/Ch9.PDF

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