Corporate Finance - Traditional Capital Budgeting - Literature review Example

Corporate Finance: Traditional Capital Budgeting Corporate Finance: Traditional Capital Budgeting Introduction Capital Budgeting is the process of planning of long term corporate project related to the investment decision of the organization. The main objective of Capital Budgeting is to allocate firm’s limited resources between competing opportunities (Harrison & John 2010). Management use various Capital budgeting techniques to make effective use of these resource to maximize firm’s value (Bennouna, Geoffrey & Marchant 2010). The key objective of an organization is to determine the investment required for expansion of the project, modernize the existing equipment to reduce the costs or to anticipate demand (Bennouna, Geoffrey & Marchant 2010). In order to make further investment, managers determine the payback period and accounting rate of returns of the long term investments (Harrison & John 2010). Though there are several Capital Budgeting Techniques, However this document shall emphasizes on significance and limitation of Traditional Budgeting Techniques (Bennouna, Geoffrey & Marchant 2010). It further comments on the statement that ‘the traditional capital budgeting techniques hold its project passively, it further states that traditional capital budgeting technique does not acknowledge the value management.’ Traditional capital Budgeting Traditional Capital Budgeting aims to measure the future cash in flows and out flows of the investment, it mainly uses the discounted rate option (Harrison & John 2010). Therefore, it is essential for the management of an organization to consider four main components to value investment opportunities, that is, accounting rate of return, payback period, present value of the project and its real option (Trivedi 2002). Following are the advantages and disadvantages of Traditional Capital Budgeting: 1- Net Present Value Advantages Disadvantages It considers all the cash flows of the project It considers time value of money and reveals the potential of profitability of any investment. It incorporates the future risks of cash flow in the estimation of cost of capital, that is, discounted rate used to calculate NPV. It calculates discount rate or the cost of capital after calculating Net Present value. The results are in the currency, not percentage. The cost of capital is not constant; it affects the value of investment. It does not calculate the future cash flows of the investment proposal. This may affect the NPV calculation that may cause errors in the results. 2- Internal Rate of Return Advantages Disadvantages IRR considers all the cash flow that are generated through investments. It allows determining the true profitability potential of the investment. It addresses the time value of money. Similarly like NPV, the risks are incorporated during estimation of discount rate. IRR is not calculates cumulative values of two project at a time. It only values one project at a time. It provides multiple results, therefore the selection criteria is difficult. The results are contradicting as compared to the results of NPV. Cash flow forecasting and future value is difficult to calculate. It is essential for Capital Budgeting Techniques to collectively address the investment decision. Although Traditional Capital Budgeting techniques are considered to highly acceptable investment rule, because it consider time value of money, measure true profitability potential, value additively and aims to maximize shareholder’s values (Jensen & Meckling 1976) (Trigeorgis 2001). However, It has bee argued that the traditional capital budgeting or investment appraisal (that is Net Present Value, Internal Rate of Return) have not developed with the modern economy which significantly uses information technology (Harrison & John 2010). Traditional capital models estimates the incoming and outgoing of the cash flows of an entity through discounted cash flow (Hirschey 2008). The appraisal decisions based on the traditional capital budgeting are constant, whereas the sustaining economic condition shall address corporate governance, capital market, accounting methods and organizations (Trigeorgis 2001). This paper supports the idea that the Projects that use traditional capital budgeting techniques do not acknowledge value of management and real options and therefore it assumes company’s project passively (Bennouna, Geoffrey & Marchant 2010). Lack of Management Flexibility Management Flexibility determines the ability of the management to make investment decision to incorporate the time, period, and existing market condition (Bennouna, Geoffrey & Marchant 2010). In order words, Flexibility can be defined as the degrees of decision making of management to adopt new strategies in response to the change in the market and economic conditions (Bennouna, Geoffrey & Marchant 2010). It is essential for the capital budgeting techniques to address issues relating to the dynamic market and economic conditions. Flexibility allows organization to make adequate decision regarding its operations with the changing market conditions. It allows organizations to take accurate decision with response to its changing scenario, this further decreases the risks that may be countered during the process. Traditional Capital Budgeting does not value the flexibility of the management. According to Gravel (2006), NPY methodology violate the principle of additively and of no arbitrage opportunities (Gervais, Heaton & Terrance 2011). It uses a single discount rate to anticipate entire project; it does not take into account any change that may be encountered during the period, such as change in the demands, market conditions, corporate governance or regulation (Bennouna, Geoffrey & Marchant 2010). Investment decisions shall anticipate future outcomes of the investment in order to minimize its risks (Jensen & Meckling 1976). According to the study of Jensen and Meckling, Traditional Capital Budgeting techniques overlooks the strategic reasons for an investment, further it does not considers the investment investments in low profitability project projecting future growth, due to this, traditional capital budget fails to address the strategic component specially the small investments (fast growing technology) organization do to maximize its profits (Jensen & Meckling 1976). Secondly, Traditional Capital Budgeting violates the principle of additively and of no arbitrage opportunities (Harrison & John 2010). This means that the traditional capital budgeting (NPV) does not values the management flexibility, as it criteria is based on ‘now or never’, this curtails the ability of the management to adapt newly arriving information and technology (Gervais, Heaton & Terrance 2011). Organizations that use traditional capital budgeting techniques have static approach to evaluate benefits and costs; it does not incorporate any change in the strategies. Real Options Real options provide alternate choices for the organization to either expand or cease the investment according to the conditions (Trigeorgis 2001). These options are ‘real’ because they pertain to tangible assets more than the other capital equipments (Jensen & Meckling 1976). Real option can be greatly affected and enhance valuation of the investment decision (Kumar & Sharma 1998). Jensen ad Meckling suggested that the Real options take account to the current issues that may arise with the sustaining conditions (Jensen & Meckling 1976). It allows organization to increase valuation of the project and further provides option that may be adopted to increase its potential. Traditional capital budgeting (NPV) is a static approach because it does not values managerial flexibility and it does not considers Real Option (Rose & Spedding 2008). As traditional capital budgeting techniques overlooks the ‘actual’ and ‘real’ condition, due to which it is unable to anticipate changes. According to Harrison and Johns (2010), it has been suggested that if Traditional Capital Budgeting Techniques includes real options it may greatly affect the valuation potential of the investment (Harrison & John 2010). Any project that is being assessed with the traditional capital budgeting method does not forecast the future anticipation. (Bennouna, Geoffrey & Marchant 2010) Though the development of technology, corporate regulation and dynamic market condition may affect profitability of the investment, it neglects the idea of abandoning, expanding or improvement of the project. Traditional Capital Budgeting does not address the options or alternative that may be adopted by the organization (Rose & Spedding 2008). These alternatives and options allow organization make it investment decisions more effectively. According to the study of Harrison and John (2010) it has been suggested that if the traditional capital budgeted incorporates real options, it may enhance the effectiveness of the investment potential of the organization, it is also suggested that the real options may further contribute to decrease risks (Gervais, Heaton & Terrance 2011). Traditional Capital Budgeting does not address provides options to either expand the project, downsize or abandoning other projects in the future (Harrison & John 2010). Therefore it is stated that the traditional capital budgeting evaluates its projects passively (Gervais, Heaton & Terrance 2011). This is because of the reason that the traditional methods provide profitability potential of the investment and anticipates the cash flows. For example, Net Present Value considers that the payments are made at the end of the period, whereas in the reality the case is different (Scialdone 2007). The payment may be made during the periods which are not considered by the traditional budgeting methods. Therefore, it can be stated that the Traditional Capital Budgeting Techniques may allow organization to anticipate investment’s profitability potential but it does not addresses the actual and real potentials (Bennouna, Geoffrey & Marchant 2010). Hence, it is evident that the projects that use traditional capital methods hold its project passively. Conclusion Analyzing the information it is evident that the Traditional Capital Budgeting allows organization to determine accurate profitability potential of an investment, but does not address the stimuli. According to the above analysis it can be determined that the Traditional Capital Budgeting technique does not take in account the real and actual conditions, that is, the corporate regulation, economic and market condition etc. Traditional Investment decisions are static; it does not address the change in the benefits and costs that are expected with the sustaining economic conditions (Rose & Spedding 2008). Therefore, the projects that use traditional capital budgeting techniques do not value management flexibility due to which it does not consider alternatives and real options. Though there are several opportunities and decision that may be considered by the organization to maximize it profits (Gervais, Heaton & Terrance 2011). One of the major challenged faced by traditional capital budgeting is that its does not incorporates the real options. Furthermore, the information reflects that the traditional investment proposal estimate cash flow with the alternative investments. It uses different discounts rate to calculate the each investment, therefore the results of the investments proposal are contradicting for mutually exclusive projects. Therefore it is suggested the traditional capital budgeting shall incorporate the real options and management flexibility to address the dynamic changes and stimuli in the business world. According to the above information and study it is evident that the projects that use traditional capital budgeting techniques do not value managerial flexibility due to which it does not accounts the real and actual options, due to which the projects are passively evaluated. List of References Bennouna, K, Geoffrey, GM & Marchant, T 2010, Improved capital budgeting decision making: evidence from Canada, Management decision, vol 48, no. II, pp. 225-247. Gervais, S, Heaton, JB & Terrance, O 2011, Overconfidence, compensation contracts, and capital budgeting., The Journal of Finance, pp. 1735-1777. Harrison, JSH & John, CHS 2010, Foundations in strategic management, South-Western Cengage Learning, Mason. Hirschey, M 2008, Managerial Economics, Cengage, Ny. Jensen, MC & Meckling, WH 1976, Theory of the firm: Managerial behavior, agency costs and ownership structure, Elsevier, vol 3, no. 4, pp. 305-260. Kumar, A & Sharma, R 1998, Managerial Economics, Atlantic Publishers, NY. Rose, A & Spedding, LS 2008, Business Risk Management Handbook: A Sustainable Approach, Elsevier, NY. Scialdone, P 2007, Valuing managerial flexibility : challenges and opportunities of the real option approach in practice, 1st edn, Göttingen Cuvillier, Frankfrunt. Trigeorgis, L 2001, Real options : managerial flexibility and strategy in resource allocation, 3rd edn, Library of Cogress Catalouging in Publication Data, Cambridge. Trivedi 2002, Managerial Ecnomics: Theory and Application, Tata McGraw-Hill, New Delhi. Read More