Capital Budgeting Decisions - Research Paper Example

? Capital Budgeting Introduction Finance is a dynamic topic that is important in various economic applications. Foundation of finance is well established to provide a stable framework of financial concepts and decision making in the economy. In addition, finance is important in the construction of financial statements, diversification in the value of money in an economy and management of capital. However, financial landscape keeps changing around the economy framework due to increase in innovation, growth of wealth accumulation, computing and networks advancement and the periodic onset of financial crises in the world. This topic has various fields such as capital budgeting which acts as an instrument in the monetary and fiscal policy. The two policies are necessary in improving net worth in the economy of a country in order to enhance development. This is mainly achieved through the reliance of debts rather than from other convectional sources such as tax. Capital budgeting is introduced in the economy so as to reduce deficit caused when expenditure exceeds revenue. In addition, capital budgeting is also primarily concerned with investment in the economy within long-term assets. These assets can either be tangible items such as equipment and property or intangible such as technology, trademarks and patents. However, the key challenge in capital budgeting is defining appropriate balances between current and capital expenditure. It is, therefore, important to enhance proper capital budgeting in order to reduce debts. This paper work analyzes a comprehensive research on capital budgeting in the economy. This is in an effort to identify some aspects of corporate practices, which are consistent with capital budgeting policies and decisions. Capital budgeting decisions Capital budgeting decisions is highly applicable in the economy to maximize market values of firms to their shareholders. The decisions, therefore, have greater and long range impacts on the performance of firms. This is because the nature of the capital budgeting decision can either cause success or failure of a firm in the economy framework. According to financial theory by Keynes, capital budgeting decisions revolve around assets values. This is by ensuring value of assets in the entire economy is equivalent to the discounted values of the expected future cash flow (Graham & Harvey, 2002). Net present value (NPV) vs. Internal Rate of Return (IRR) These are two capital budgeting decision measures that are used to evaluate the nature of the product market before undertaking investment project. This means that firms contemplating investment in the capital market need to embrace net present value (NPV) rule in order to know when to undertake projects. According to this rule, a firm is only required to undertake capital investment project when NPV is either zero or positive. However, current survey shows that many firms across the world use internal rate of return (IRR) as a primary criterion of evaluating capital investment projects (Gervais, 2009). According to a survey that was conducted in 2000 among large companies in the world, 10 percent of them relied on NPV as a primary source of business evaluation while more that 50 percent relied on internal rate of return. Although the two methods have a similarity in evaluating the nature of the market, they exhibit critical difference in that IRR is expressed in ratio form while NPV measures the value added in dollar. However, Dayananda indicates that research shows that most of the companies and firms across the globe uses internal rate of return and net present value for their capital budgeting techniques. In addition, large firms record high rate of using NPV than small companies. This is because they require more accurate measure to prevent incurring higher losses because they engage in paramount investment (Dayananda, 2002). In addition, some surveys show that NPV is also like to be used by firms with high leverage than IRR contrary to firms with a reduced debt ratio which use IRR. This, according to Gervais, can be explained by economic theories which argue that debts in finance exert pressure in firms’ capital investment decisions. Moreover, firms which pay dividends to shareholders who have higher record of using NPV than those that do not pay dividends. Non-dividend paying firms are likely to use IRR because their investment is difficult to quantify and thus their expected cash flow takes longer time to materialize (Gervais, 2009). Overconfidence vs. Optimism Overconfidence and optimism are other capital budgeting decision measures affecting the undertaking of investment projects. It is evidenced that managerial optimism and overconfidence can either lead to an increase or a decrease in the value of firms’ investments. Overconfidence in most cases leads to underinvestment because most of the firm managers sometimes overturn projects based on negative information. In addition, Dayananda indicates that overconfident managers are fond of underestimating investment risks. They, therefore, postpone capital budget decision undertakings even for very potential projects. In other situations, overconfident managers are also beneficial to firms because they facilitate expansion of investment efforts due to their overestimation nature (Dayananda, 2002). Overconfidence can also be beneficial in a firm because odd risks are normally viewed as successful ideas. Graham and Harvey found out that overconfident managers take less time collecting information in the product market. Moreover, overconfident managers always avoid losing their perceived projects out of competition and thus undertake any risky project with little information about it. This has a greater effect on firms’ value because the value in the economy is only gathered through gathering of information (Graham & Harvey, 2002). On the other hand, some surveys have indicated that sometimes firms are optimistic about future events in an unrealistic way. This is because every firm expects better returns from its investments more than to its competitors in the product market. Optimistic managers, therefore, have a likelihood of undertaking projects quickly without considering risk factors in the market. According to the research conducted on the product market of various firms across the globe, foreign companies are more optimistic on how changes in exchange rates across global market affect them more than others. In addition, optimistic managers do not hesitate in undertaking projects because they believe their expected net value of any potential investment is always greater than its actual value. Generally, although optimistic and overconfident managers are all eager to undertake projects they do so in different perspectives (Graham & Harvey, 2002). Techniques used in capital budgeting Firms use various techniques in evaluating their capital investments. Some techniques use easy calculations and are easy to grasp while others are complicated. The bottom line is that managers at various levels prefer a technique that is 1) easily applicable, 2) puts into consideration cash flow, 3) recognizes time value of money, 4) accounts fully for the expected returns and risks, and 5) if applied, it will lead to higher value of the firm or higher stock prices for the public firms (Graham & Smart, 2011). Some of the easy techniques used also comprise the traditional methods such as the payback period and discounted payback. These are used by smaller firms that do not have the financial and human resources to conduct the more complex techniques. These, however, do not take into account the 1-5 issues mentioned above. Discounted cash flow technique is a more complex way of analyzing capital budget. This technique makes use of net present value, internal rate of return and profitability index to determine viability of a capital investment project. These techniques enable better decision making as they take into account the 5 issues. Particularly, the net present value gives direct changes of share value due to a particular investment (Graham & Smart, 2011). Payback methods This is the simplest of all techniques used in capital budgeting. Payback period refers to the time it will take for a project’s cumulative cash flow to make return to the initial investment. Firms using the payback method define the maximum payback period acceptable to the shareholders. These firms will only accept projects whose payback period is shorter than the maximum period stipulated. All other projects that exceed the payback periods are rejected. If several projects qualify within the payback period, the firm prioritizes the projects depending on which one makes the most rapid payback (Graham & Smart, 2011). Discount payback method The discounted payback period is similar to payback period technique except it takes into account time value of money. This technique considers time needed to regain initial investment while considering the present value of cash inflows. This works by adding the discounted cash flows until it matches the initial investments (Graham & Smart, 2011). Discount cash flow techniques Discounting cash flow technique is complex and used by larger firms. The advantage of the technique is that it provides a better analysis of capital budgeting. This technique involves determining the cash flow increments, time value of money using net present value and discount rates through capital costs (Graham & Smart, 2011). Incremental cash flows In understanding incremental cash flows, two rules are observed. First, the annual cash flow and not profits and losses are used in discounting cash flow technique. Annual cash flow is different from profits and losses as it considers the working capital and depreciation. Secondly, only incremental cash flow is used in evaluating an investment project. This means cash flows resulting directly from the decision to accept a particular project are to be considered only. In determining the incremental cash flows, opportunity costs, working capital, depreciation and taxes should be considered. Sunk costs and accounting costs should not be included (Clayman, Fridson & Troughton, 2012). Working capital refers to the expense the firm has to pay before they realize any benefits. The pay roll, for example, has to be paid before receiving revenues from that day’s work. In addition, taxes are a part of life and have to be considered while making any financial decisions. Further, depreciation has to be considered. Depreciation is an expense, which does not constitute negative cash flow. On the contrary, depreciation results in tax shield for the firm hence acting as a positive cash flow as it offsets taxes. All capital assets depreciate and this depreciation is accounted twice in cash flow calculations. Depreciation is deducted once to calculate taxes paid on project revenues and then added back to realize cash flows. Overhead should also be included in arriving at incremental cash flows. A firm looking to set up a new branch, for example, its incremental cash flows, would include cost of investments, operating new offices and costs avoided were it to abandon the investment project. It would also include looking at the benefits and revenues the project would bring to the firm (Clayman, Fridson & Troughton, 2012). In calculating the increment cash flow, firms experience problems with three concepts including sunk costs, opportunity costs and externalities. Sunk costs are expenses incurred and cannot be recovered regardless of whether the project is undertaken or not. These should not be included in the capital budgeting analysis as they are not part of incremental costs. Sunk costs include such expenses as hiring. Many policy makers in firms find it hard to ignore psychologically sunk costs. Due to the incurred costs, there is a natural tendency for firms to carry on with a project even if evidence indicates the project will not succeed a behavioral process referred to as escalation of commitment (Clayman, Fridson & Troughton, 2012). An opportunity cost is the total asset worth in light of alternative uses. It is considered a cash flow that can be obtained from the asset already owned by the firm and not used for the proposed project. If the firm, for example, owned a piece of land on which it hoped to set up the branch but reconsidered the project, it could sell the land instead of ignoring it. Externalities, on the other hand, are used in economic terms to suggest that a firm should account for effects regardless of whether positive or negative, directly caused as a by-product of the firm’s activities. Opening up a new branch, for example, will reduce the amount of business activities at the main office. This effect should be accounted for in the capital analysis (Clayman, Fridson & Troughton, 2012). Time value of money In addition to cash flows, firms have to establish the cost of funds needed for a project. Time value of money is a concept used to determine the value of the investment, the cost of funds and the yield of an investment. This concept allows asset and financial managers to translate future cash flows into present value and translate present value into a future value to determine the yield of the investment. The mathematics of time and value allows for comparison and evaluation of various projects to determine which would be more profitable for the firm. Time value for money is calculated using the net present value. First establish the discount rate then calculate present value for each year’s cash flow. Sum the future present value and subtract it from the investment to determine the net present value (Fabozzi & Peterson, 2009). Discount rates Cost of capital should also be considered in evaluating a project. Capital is obtained from savings of the company, through borrowing in terms of loans or bonds or selling of shares. If the money for funding the project is obtained from company savings, the cost of capital is determined by rate of returns if the money was to be used on alternative projects. If borrowed, the cost of capital is the amount of money paid in interests (Fabozzi & Peterson, 2009). Making a decision When deciding on the project to pursue, it is important that policy makers follow a criterion depending on the circumstances. If the objective of the firm is to bring in profits while increasing shareholders’ wealth, the project accepted should have a positive NVP. Secondly, if projects are mutually exclusive meaning they cannot be combined such as building a bridge or buying a ferry, the project with highest positive NVP should be chosen (Clayman, Fridson & Troughton, 2012). In addition, a firm should carry out sensitivity analysis. The assumptions made during capital budgeting must be challenged. Since estimates are wrong, it is important to weigh them out to avoid making a wrong decision. Sensitivity analysis refers to the repetition of the analysis using different values of a certain variable such as annual operating cost. These values are changed by specific percentages and the resultant effect is noted. This process helps identify important variables in the project and in the risk assessment of the project (Clayman, Fridson & Troughton, 2012). Conclusion This research has clearly analyzed capital budgeting decisions in the economy. The decisions are mostly used during financial planning to determine whether the firm should accept or reject a project. There are several measures that are mostly used by firms to access the nature of the projects before they are undertaken. Net present value (NPV) and internal rate of return (IRR) are the common methods that are used by many firms across the world to identify the efficiency of a project. If both methods give negative outcomes the project should not be undertaken, but when the results are positive, the project should be initiated. In addition, overconfidence and optimism have an impact on capital budget decision. Gains from overconfidence and optimism managers are at times sufficient in decision making during investment. Capital budget analysis is one of the most important decisions a firm can make. During this process, managers should determine the economic life of the project and the incremental cash flows. They should also determine the discount rate, calculate the NPV and order the various projects according to NPV. Further, managers should conduct sensitivity analysis to make a decision on most appropriate project. Following the analysis, a firm should implement only what it can afford. References Clayman, M. R., Fridson, M. S., & Troughton, G. H. (2012). Corporate finance: A practical approach. Hoboken, N.J: John Wiley & Sons. Dayananda, D. (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge: Cambridge University Press. Fabozzi, F. J., & Peterson, D. P. (2009). Finance: Capital markets, financial management, and investment management. Hoboken, N.J: Wiley. Gervais, S. (2009, November 24). Behavioral Finance: Capital Budgeting and Other Investment Decisions. Retrieved June 19, 2012, from faculty.fuqua.duke.edu/.../BookChapter.OvCapitalBudgeting.pdf Graham, J., & Harvey, C. (2002, August). HOW DO CFOS MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS? Retrieved June 19, 2012, from faculty.fuqua.duke.edu/~jgraham/website/SurveyJACF.pdf Graham, J., & Smart, S. B. (2011). Introduction to Corporate Finance and Economic Coursemate + Access Card + Thomson One Business Access Card. South-Western Pub. Read More