The Application of Traditional Capital Budgeting Techniques - Assignment Example

?Critically appraise the application of traditional capital budgeting techniques Table of Content Introduction 2. Capital Budgeting and Post Completion Auditing 2.1 Objectives of capital budgeting 2.2 Developments in the Application of the Techniques 2.2.1 The Role of Post-completion Auditing 2.3 Analysis of Research methodologies 2.4 Findings 2.5 Knowledge and Use of Academic Literature 2.6 Critical Review 3. Conclusions 4. Recommendations Abstract With the turn of the 21st century, the global business environment has undergone tremendous changes, which brought about many positive and negative consequences. Globalization and related pressures significantly boosted global market competition, and that in turn led to technological advancements and business innovations. At the same time, many business organizations failed to survive stiff market competition and subsequently went out of the market. The last decade witnessed a series of corporate scandals and bank failures due to poor managerial accountability and ineffective corporate governance practices. Hence, today’s managements give particular focus to corporate governance principles and long term business decisions. In this context, the concept of capital budgeting is of considerable significance because it evaluates future cash inflows and outflows on a prospective business project and thereby determines it potentiality. After the global financial crisis 2008-09, capital budgeting is specifically considered to be an integral part of the financial management. This paper clearly describes how the capital budgeting technique can contribute to the long term sustainability of business organizations. In addition, the influence of capital budgeting on managerial efficiency and organizational performance is also explained in this paper. Some recent developments in the application of capital budgeting have increased this method’s relevance in the modern business context. Today, firms widely use this financial planning tool to make potential decisions regarding mergers and acquisitions. The scope and significance of post-completion auditing are also detailed in this work. 1. Introduction A variety of methods are used in capital budgeting including payback period, net present value, accounting rate of return, internal rate of return, equivalent annuity, profitability index, real options valuation, and modified internal rate of return (Drury & Tayles 1997). The method used for capital budgeting may vary with regard to the change in size of the business. Simply, capital budgeting is a tool used for long term decision making. Although capital budgeting is traditionally used for making sound long term investment decisions, many other real-life applications of this technique have been developed recently. Capital budgeting is a complex process and therefore careful management of this process is vital to achieve the desired outcomes. A post project audit is conducted to evaluate the completed project. More precisely, under a capital investment project, actual cash inflows and other benefits are compared with figures forecasted at the time of project appraisal. This paper will analyze the objectives of capital budgeting, recent developments in its applications, and the role of post-completion auditing. 2. Capital Budgeting and Post Completion Auditing Capital budgeting can be simply referred to the planning process deployed to evaluate whether or not a firm’s long term investments including new plants, new machinery and products, and research and development project are worth pursuing. In a broader sense, “capital budgeting can be defined as the analysis of a proposed investment that is a long-term asset used by the business to yield a return over a period of time that is greater than one year” (Williamson et al 2008, n.a). Management experts argue that capital budgeting can also enhance the growth of non-profit organizations because potential long term investment decision would assist those institutions to expand their area of operation. The process of capital budgeting has six phases including identification, search, information acquisition, selection, financing, and implementation and control (Whittington & Delaney 2011, p.181). Unsurprisingly, the scope of capital budgeting is varied in cases of for-profit and non-profit enterprises. While planning their capital budget, for-profit organizations take higher levels of risk as compared to non-profit enterprises. In contrast, non-profit organizations just try to secure their current volume of revenues by investing only in safe projects. Post-completion auditing is extremely vital to evaluate the efficiency of the project appraisal made by the management (Papageorgiou et. al 2011, p.11). In addition, this process is better to identify the areas of excellence and improvement in the capital investment project implemented. Hence, it is a better practice to improve capital investments next time and to promote the sustainability of the organization in the long term. 2.1 Objectives of capital budgeting One of the major objectives of capital budgeting is to determine project scope; and by using the capital budgeting technique, project planners can assess the financial scope of a project effectively (Herbst 2002, p.5). Since the capital budgeting process begins long before the project is commenced, it is possible to determine how much money the organization needs to spend on each individual area of the project. For instance, when a manufacturing plant undergoes a renovation process, the management can decide how much it is going to spend on installing energy-efficient heating mechanism with the help of capital budgeting method. Since capital budgets make provisions for downtime, it can spell out the scope of the project in terms of the time expected for the project completion. In addition to spelling out the details of the project expenses, the capital budget also specifically states the sources of money to pay for the project (Musell 2009, p.48). Therefore, determining funding sources is another objective of capital budgeting. Generally, these funding sources may include cash, bank borrowing, investment account, stock offerings, and government and other external grants. Usually, project planners consider a mix of those funding sources to facilitate the execution of the project. Capital budgeting also aids project planners to determine how money should be acquired from each source and the exact costs of using that particular funding strategy. Determining payback method is an important objective of capital budgeting (Keown et. al 2005, p.292). Normally, firms invest in a new building, new machineries, or a renovation process with intent to pay gradually to itself. It is obvious that some projects can pay for themselves faster than what others do. There are several techniques to choose the potential payback method for a project. A capital budget helps to identify the most effective payback method the company needs to use. The capital budgeting process is also capable of estimating the time span required for the business to realize a return on its capital investment. Management professionals indicate that controlling projects costs is a major objective of capital budgeting (Blocher 2006, p.841). A capital budget acts as the key cost control document throughout the lifetime of the project. Throughout the course of the project, the project managers record costs incurred and try to keep the project costs within the budget. When there is a possibility of cost underrun or overrun, the project manager can take adequate measures to address the issue and hence complete the project as planned. Usually, capital budget formulated for a particular capital investment project is maintained until the completion of the payback period. Another important objective of capital budgeting is to make provisions for ongoing capital purchases such as repairs, preventive maintenance, and software upgrades. Since many of these capital expenses occur unexpectedly, capital budgets set aside special reserves to meet those expenses in a crisis situation and not to meet additional debt. This practice greatly assists organizations to keep their projects and other operations running even in the midst of an emergency situation. In sum, a better execution of the capital budgeting process would benefit the organization to keep in pace with the projected growth. 2.2 Developments in the Application of the Techniques As discussed earlier, though traditionally capital budgeting technique was used for evaluating the soundness of capital investments such as new plants and new products, now this method is being deployed for a wide variety of purposes. Today the scope of business mergers and acquisitions has dramatically increased because many firms perceive M&A as potential strategy to survive in the current highly competitive market environment. Currently capital budgeting is considered to be a better tool to evaluate the feasibility of M&A decisions. Under the capital budgeting method, merger decisions are generally assessed on the basis of determination of exchange rates and effect on earnings per share (Block & Stanely 2009). However, free cash flows must be emphasized more than earnings per share (Ibid). Generally the proposal for a business acquisition is supported if the net present value (NPV) of the acquisition is positive (Vasconcellos & Madura 1988, p.20). In contrast, if the NPV of the acquisition is negative, the acquisition proposal is not likely to add to shareholder values. More clearly, project managers need to value the target company while dealing with a merger/acquisition proposal. Evidently, valuing a business firm can be easily done using the capital budgeting technique. A discounted cash flow model is used under the capital budgeting method to evaluate M&A decisions (Vallabhaneni 2013, na). Management professionals say that capital budgeting is very helpful for firms to evaluate M&A proposals, particularly if they are of huge size. In addition, nowadays capital budgeting is increasingly used for scrutinizing the potentiality of market expansion plans such as joint ventures, Greenfield investment, and other strategic alliances. Therefore, this technique plays a great role in expanding the market size of organizations. Software conversion is one of the recently developed applications of the capital budgeting strategy. Evidently, a company needs to change its software over time in order to meet the growing needs of the business. For instance, the current accounting software may fail to recognize latest accounting changes and hence it requires an immediate software conversion. Similarly, the current time keeping system may require supervisors to enter employee working time manually. As it is a time consuming task, an improved time keeping software needs to be installed to scan such data automatically. Evidently, software conversion or upgrade is a capital expenditure and it requires employee time to implement the change and to train other employees for handling the new system. Furthermore, it also requires the organization to identify proper financial channels to finance the software purchase. Here, the organization can effectively manage this process by including a software conversion project in its capital budget. Finally, capital budgeting is also applied to computer equipment upgrade. It is clear that today all the businesses use some or other forms of computerized technology in their offices and manufacturing plants. In addition, the office staff use computers and related technologies to maintain different records and to communicate with clients or vendors. As the needs of the business grow, companies should consider an upgrade or replacement (whichever is necessary) of the current computer equipments. Hence, the capital budget must include provisions for upgrade or replacement of computer equipments. 2.2.1 The Role of Post-completion Auditing As mentioned above, the major role of the post completion-auditing is to compare the actual outcomes from the capital investment with those estimated at the time of project approval (Drury & Tayles 1997). It also assesses the way the investment project is managed and performed. A properly performed post-completion audit would assist the business to improve operational efficiency on a continuous basis. Post-completion audits are considered as the end stage of the investment process and are performed after the commissioning of the project. Usually, this process is carried out during the outcome period or immediately after the end of the outcome period. It is identified that many companies perform post-completion audit 6-12 months after the project commissioning. In some cases, project outcomes may spread over several years. Under such circumstances, an early post-completion audit cannot spell out the actual scenario and therefore further follow-up audits are performed to obtain a clear view of the longer term project outcomes. Some scholars opine that this process can be carried out any point after the beginning of the project and need not to wait until the completion of the project. Nowadays post-completion auditing of investment projects is considered as an integral part of the capital budgeting process (Dunlop 1998, p.53). Post-completion auditing plays a crucial role in improving the quality of decision making process. These audits can provide managements with valuable information regarding project performance and managerial efficiency and therefore managements can obtain good understanding of necessary changes that need to be made to the decision making process. Another role of post-completion auditing is to enhance the realism of project appraisals. This practice is essential to avoid biasing upwards of cash flow in investment proposals. Evidently, this type of auditing is extremely helpful to strengthen corporate performance. To illustrate, post-completion auditing is beneficial for firms not to choose projects with poor yields. Identification of key variables is also a major role of this post-completion evaluation process. As seen already, sometimes the planned outcomes of the project may be different from the actual outcomes realized. It is vital to understand the key variables contributed to the change in order to plan the future capital investment projects effectively. Experts suggest that a well-structured post-completion audit can identify the key variables causing the change. In the opinion of experts, improving internal control mechanisms is one of the key roles of post-completion auditing. It is precise that this audit would assist project planners to identify flaws of the project implemented and areas of cost overruns if any and this information in turn may point to the weaknesses of the firm’s internal control mechanisms. Thus, the management can take some immediate actions to address the issue. It is observed that managements are often unwilling to terminate unsuccessful projects although it is the only logical action to take. However, performance of post-completion audit would give the management the key information about the inevitability of termination decision. Thus, post-completion auditing is helpful for organizations to reduce financial losses incurred from a capital investment project. Finally, enabling quick adjustments to underperforming projects is also a major role played by post-completion audits; and this is a prime feedback function of post-completion appraisal (Dunlop 1998, p.53). 2.3 Analysis of Research methodologies Capital budgeting is a broad area of study and therefore different researchers use different methodologies to explain this topic. In 2002, a group of researchers including John Graham and Campbell Harvey (2002) conducted a study and summarized their findings in the article titled ‘How do CFOs make capital budgeting and capital structure decisions?’. For this study, the researchers approached nearly 4,440 companies to obtain responses from their management officials. Graham and Harvey mainly used questionnaire survey methodology to collect responses required for their study. The survey contained nearly 100 questions which address two key areas – capital budgeting and capital structure decisions. They received 392 completed surveys (Ibid). It seems that questionnaire survey is the most common methodology followed by academic researchers to collect responses from individuals, business organizations, and government bodies. The most advantageous feature of this method is that it is less expensive. In addition, this methodology is easy to administrate. Many experts believe that this is the right method to collect responses from a large number of companies or busy scheduled people. However, this research methodology has a number of shortcomings too. First, all the participants may not necessarily respond to all questions properly under the questionnaire survey methodology due to lack of time or negligence. Second, busy managers and other officials are less likely to complete and return their responses within the time specified. Here, it is obvious that Graham and Harvey received only 392 completed surveys even though they solicited responses from nearly 4,400 companies. It is possible to overcome such issues by including more participants than necessary. Similarly, Andor et al (2011) prepared a research paper titled ‘Capital budgeting practices: A survey of central and eastern European firms’. As part of collecting information about capital budgeting practices of firms operating in CEE countries, they conducted telephone surveys and collected 400 responses through this methodology (2011). Evidently, telephone survey is the best methodology to collect needed information completely and in depth. Since telephone survey involves direct communication between the surveyor and the participant, there is less chances of misinterpretations. Likewise, it is possible to record the interview while conducting telephone surveys and this practice may contribute to accuracy and reliability of the information collected. High accessibility is one of the major benefits of telephone survey methodology. Today, over 95% people own a mobile phone. However, it is to be noted that it would be very difficult for researchers to get connected to busy executives and other top level company staff through phone. This research methodology would better serve the interests of anonymous respondents who wish to keep confidentiality of their opinions. Quick data processing is another major merit of telephone surveys. The major limitation of telephone survey is that the interviewer cannot ask all questions listed unless the respondent has enough time. Due to this issue, the interviewer may not obtain a clear picture of the subject and this problem would limit the scope of the research. 2.4 Findings The above sessions give a detailed view on objectives of capital budgeting, recent developments in its applications, and the role of post-completion auditing. It is clear that capital budgeting is of particular importance in making sound decisions on capital investment projects. More precisely, capital budgeting is a tool to evaluate the possible risks and rewards of a particular investment decision. Business managers use this method to assess possible costs associated with an investment over its lifetime. In addition, this approach is very helpful to evaluate how investment costs are correlated with business earnings. It can be claimed that capital budgeting is a financial planning tool that assists businesses to stay away from the risk of poor or costly investment decisions. Availability of multiple budgeting methods is one of the great advantages of the capital budgeting technique. This feature is beneficial to meet varying needs of businesses. To illustrate, profitability or soundness of an investment can be analyzed using the ‘net present value’ capital budgeting method, which pays particular attention to cash flows and possible risks of future cash flows. Similarly, the ‘internal rate of return’ capital budgeting technique assists a firm to identify investments or projects that would generate highest internal rate of return. An organization can freely choose the most appropriate capital budgeting technique to obtain most complete and accurate information concerning a particular investment. Evidently, risk assessment is another notable benefit of capital budgeting. Using this technique, business managers can review potential investments and projects individually and objectively. This financial planning tool also provides the management with an opportunity to compare the value of a particular project/investment with business plans and goals of the company. In addition, it also gives managers the opportunity to assess whether or not a particular investment/project makes financial sense for the firm. In short, capital budgeting technique aids a business concern to evaluate the anatomy of a capital investment, which in turn assists the management to identify the elements of risk involved. Furthermore, this technique is advantageous to predict potential return on the investment. Several capital budgeting techniques can be used to forecast the future value of an investment by evaluating its current value. Using capital budgeting technique, a firm can better identify the investment tool that would provide it with best possible return. The most potential feature of capital budgeting is that it benefits organizations to effectively deal with long term planning. To illustrate, this method assists the management to form long term goals, to review different investment opportunities, and to anticipate the outcomes of long term projects. Once the project is commissioned, post-completion auditing tool is used to compare the actual outcomes of the project with those forecasted at the initial stages of the project planning. As discussed already, post-completion auditing is an integral part and end phase of the capital budgeting. This post-audit tool can be effective to analyze the overall success of the capital budget framed. In short, capital budgeting together with post-completion auditing is inevitably important for businesses to run their projects/investments profitably and to enhance sustainable growth in the long run. 2.5 Knowledge and Use of Academic Literature Obviously, there is a close link between corporate finance and investment decisions. This relation is clearly explained by Myres. According to Myres (1974), capital budgeting is a key tool to make potential investment decisions. The author adds that the capital budgeting plays a significant role in connecting corporate finance to investment decisions (ibid). Froot and Stein (1997) indicate that capital budgeting is of significant importance in the current market environment where the level of uncertainty is high. Today, business managers struggle to anticipate market risks due to the pressures of financial market fluctuations and other global market changes; and in this context, the capital budgeting techniques helps organizations reduce their business uncertainty to some extent (ibid). Since this method is capable of assessing the value of an investment/project and its possible future returns, it can reduce the elements of risk involved to a great extent (ibid). The Capital Asset Pricing Model (CAPM) is an important tool used for the capital budgeting purpose. In his paper, Jeremy (1996) clearly spells out the relevance of CAPM in the capital budgeting process. The writer argues that the CAPM model still remains to be a very useful tool of capital budgets in spite of growing criticisms against the functionality of this model; and at the same time, the author admits that the use of CAPM cannot be justifiable in all circumstances (ibid). Jeremy points that when managers plan for a short term period or when the firm is challenged by financial constraints, the CAPM is not advisable in the sense that it does not give a clear picture of the expected returns on stocks (ibid). The scope of capital budgeting is not restricted to just financial investment decisions, but it can also support mergers and acquisition and other business expansion plans. Authors like Shim and Siegel have researched the scope of capital budgeting concept in today’s business environment. In the words of Shim and Siegel (2009), a company needs to make a variety of investment decisions to promote growth. The authors contend that the capital budgeting technique can be best applied to make decisions on selling of a business segment, leasing, or buying (ibid, p.263). When it comes to post project evaluation or post-completion auditing, it is clear that this process would benefit the project management team more in their future operations. As Nagarajan (2005) points out, each post-completion audit adds to improvement in the firm’s project management efficiency. The author holds the view that “the project owner and the project management team learn a lot during the course of project implementation and they become a store house of knowledge which they can share with others or use them in their future ventures” (Nagarajan 2005, p.210). 2.6 Critical Review The tool of capital budgeting can be considered as a path finder to potential capital investment opportunities. This technique is not only applicable to business landscape, but also used by national governments to formulate sound fiscal policies. According to an IMF working paper, capital budgeting technique is very effective to “improve the net worth of the government” and it also assumes the role as “vehicles of economic development”, particularly in the field of economic infrastructure (Jacobs 2008). The author also opines that there is little incentive to strengthen the debate on the relevance of capital budgets in governmental operations because many of the advanced countries use their budgetary surpluses to reduce the levels of public debt but not to promote investments (ibid). Despite many criticisms, the importance of capital budgeting has significantly increased over time. Many of the developed counties including most OECD countries have achieved a high level of integration of their current and capital budgets. Economists strongly suggest that a well developed capital budgeting process must be the central component of a potential over-all budgeting system. It is identified that ‘net present value’ and ‘internal rate of return’ are the most common forms of capital budgeting techniques used by corporations (Gupta & Mohanty). It can be claimed that the capital budgeting method gives particular reference to cost-benefit analysis while making decision on a specific investment/project proposed. In most cases, costs and benefits are appeared to be spread over several time periods and therefore it is particularly important to emphasize the time value of money (Bierman, n.d.). 3. Conclusions From the above discussion, it is clear that capital budgeting and post-completion auditing can have a great influence on formulating potential capital investment decisions. Capital budgeting is a financial planning tool that evaluates the feasibility of a particular investment/project planned whereas post-completion auditing is an appraisal tool that assesses success of an investment made or project implemented. The capital budgeting process has six phases and it ends where post-completion audit begins. The major objectives of capital budgeting include identifying project scope, finding funding sources, determining payback method, controlling project costs, and facilitating ongoing capital purchases. The importance of capital budgeting has increased over the years and currently its scope is not limited to just making investment decisions. In addition, this budgeting process is also applied in mergers and acquisitions, software conversion, and computer equipments upgrade. Although capital budgeting process is thought to be end with project implementation, it is actually completed with post project evaluation or post-completion audit. The post-audit is generally performed 6-12 months after the commissioning of the project. The major role of such an audit is to point out the gap (if any) between planned outcomes and actual outcomes. This information would assist the project planners to identify the areas of weaknesses and hence to improve future performance. Scholars suggest that capital budgeting is a key tool to assess the correlation between investment costs and business earnings. There is a range of capital budgeting techniques such as net present value and internal rate of return available to form potential capital investment decisions. CAPM is a major tool of capital budgeting despite the ongoing debates on the topic. It is also identified that capital budgeting technique can greatly support government’s efforts to promote economic growth. 4. Recommendations In order to make capital investment decisions extremely potential, it is necessary to improve the capital budgeting process. It must be noted that capital budgeting is not a stand-alone process. “To effectively make investment decisions, capital budgeting must be integrated with operational budgeting and testing of strategic plans and operating tactics. In this way capital budget can be optimized and can drive the annual planning process” (Mowrey, n. d.). Experts claim that capital budgeting together with operational budgeting can provide the management with a better understanding of the investment proposal. In addition, this strategy is effective to minimize the level of risks to a great extent. It is also to be noted that business managers have to completely assess the current business strategies and assumptions before developing both capital budgeting and operational budgeting plans. This is particularly important because the modern business environment is characterized with high possibility of change and increased competition. It is recommendable for project planners to have well understanding of strategic objectives of the firm. This information would greatly assist them to evaluate whether or not the proposed investment/project goes in line with the needs of the firm (Deloitte 2009). It is identified that sometimes even a well planned capital investment project causes issues like cost overruns and delayed execution due to improper management project risks; and therefore, it is particularly advisable for project leaders to identify and manage risks and each stage of the development (Ibid). This strategy is beneficial to complete the project successfully and to implement it timely. Similarly, it is necessary to improve the accuracy and reliability of post-completion audit because it is the key tool to evaluate the success of the project executed or investment made. For this, even small expenses associated with project management have to be recorded. This practice would assist the managers to obtain an accurate view about the actual project costs realized. Before commencing the post-audit, the management must review the time period over which project outcomes are spread. If the actual project outcomes are spread over a period of three years, it is of no use to carry out post-completion audit 1 year after the commissioning of the project. References Andor, et al. (2011) Capital Budgeting Practices: A Survey of Central and Eastern European Firms. Research paper. [online] available at [accessed 21 April 2013]. Blocher. (2006) Cost Management. New Delhi: Tata McGraw-Hill Education Bierman, H. (n. d.) ‘Capital Budgeting: The Dominance of Net Present Value’. QFinance. [online] available at Read More