Aspects and Techniques of Capital Budgeting - Coursework Example

Capital Budgeting Name Institution Date Introduction Capital Budgeting is an exceptionally significant aspect in the financial management of a firm. Although the capital assets usually comprise of a smaller percentage of their total assets than the current assets, capital assets are perceived to be long-term. Consequently, a firm that indulges into a mistake within its capital budgeting process is forced to live with such a mistake for quite a long period of time. This defines capital budgeting as the process through which a business evaluates whether or not investing in projects such as developing a new plant or in the long-term ventures are worthy pursuit. It involves assessing the cash inflows and outflows of a prospective project’s lifetime so as to if the returns generated are able to meet a satisfactory target benchmark (Levy & Marshall, 1994). Capital budgeting, which is also referred to as investment appraisal is vital in marketing decisions. For instance, decisions on investments that considerably takes long time to mature need to be determined on basis of the returns for which that particular investment will make. This suggests that unless the project is intended for social reasons, if that investment emerges to be unprofitable within the long run, then it becomes risky to invest in it. Since the concepts of capital budgeting is considered as a managerial tool, it becomes important to note that one of the major duties of a manager is to select investments that have satisfactory cash flows, rates of return as well as worth undertaking with the ability to choose wisely from two or more alternatives. Therefore, in order to achieve this, a sound procedure is required to select, compare and evaluate a project to invest in, and thus the need to undertake capital budgeting (Emery, Finnerty & Stowe, 1998). Capital budgeting projects such as the potential long-term investments generate cash flows for several years. Therefore, the decision to either accept or reject a given capital budgeting project is dependent upon the analysis made on the cash flows that is generated by a project and the associated costs. Playback Period, Net Present Value and Internal Rate of Return are the key decision rules used in capital budgeting. This implies that a capital budgeting decision rule is expected to satisfy criteria such as take note of the entire cash flow of a project, the Time Value of Money as well as be on the lead to take the right decisions when it comes to choosing among the mutually exclusive projects. The principles and activities of capital budgeting are considerably important in business since a vast amount of money can easily squandered in case the investment turns out to be either uneconomic or wrong. As a result, the process seeks to develop on the idea of future value of money that could be spent at present by examining the various techniques of the net present value, annuities as well as internal rate of return. The ability to time cash flows is vital in the new investment decisions (Dayananda, 2002). Aspects of the capital budgeting process and why each one is crucial to the success of an organization As an entrepreneur, one will often be presented with a variety of potential opportunities. This indicates that as a company it will go in several directions, and as a result the company will need to consider the identification of opportunities as the basic step in capital budgeting process prior to making decisions (Pinches, 1996). The next step is to assess the identified opportunities individually. The manager has to compare each opportunity against own vision for the company as well as the mission statement. This involves assessing the values of each opportunity to examine whether or not match with the own set values. As a result, a number of the potential opportunities may be eliminated within the step before one can get into the required financial information. The manager is required to only pursue such opportunities that match his or her business plan (Scott et al. 1999). Cash flow assessment is also another critical step in capital budgeting process. This is a must to the new projects where the manager is expected to estimate the total amount of cash that may be required to complete a project and the amount for going forward with the project. For instance, if one is intending to start a new plant for the business, he or she will be required to consult with an architect and perhaps a builder so as to determine the total cost that will be incurred. In the second cash flow assessment process, the manager determines how much money the project that he or she intends to invest in could bring. However, a consideration has to be given on the numbers calculated so as to avoid using the best case scenario and use numbers which are more realistic for own assessment. This is a section that enables the manager to determine whether or not the project is viable (Droms, 1997). The ultimate step in capital budgeting process is making decisions. The main aim of capital budgeting is to enable the manager make viable decisions which are smart for his or her business. Therefore, the ability to take the necessary steps so as to evaluate each opportunity helps the manager to avoid disastrous consequences for the business. However, if such steps are not taken, one can take on the project which does not bring in any value to the company. This clearly indicates how capital budgeting process is a crucial aspect that needs to be considered before involving in any decision making for a given project (Harvey, 2005). Techniques of Capital Budgeting based on Independent and Mutually Exclusive Projects The ability to understand the classification of capital budgeting within projects plays a vital role in analyzing the viability of such projects. In this case, a project whose cash flows are examined to have no effect on either acceptance or rejection of some other projects with a firm is considered to be an independent project (Pinches, 1996). Therefore, all the projects that meet such criterion must be accepted. While a set of projects out of which the most viable is accepted is referred to as mutually exclusive project. This suggests that within the mutually exclusive projects, the cash flows of a single project may be adversely affected by the emerging acceptance of other projects, but all are expected to accomplish the same task. Therefore, while in the processing of choosing among the mutually exclusive projects, it means that two or more projects will be able to satisfy the capital budgeting criterion, but only a single a project will be accepted. Accepting which projects to invest in largely depends on factors such as initial investment, the strategic significance of a project as well as the time period that may be required to complete the project. It becomes apparent that a project which increases the value of a business within the long run will be considered for selection. In order for the firms to achieve improved and centralized strategic planning across its business operation, it is required to master a capital budget cycle (Kent Baker, 2011). Methods for capital budgeting decisions A number of measures have evolved over time in the attempts to analyze the request made on capital budgeting. Good methods make use of the concepts of money value. However, older methods such as payback period, lacks the ability to use time value techniques. Thus expected to fall on the wayside and become replaced by newer and superior method of evaluation. Other methods a part from payback period include Net Present Value (NPV) and Internal Rate of Return (IRR). 1. Net Present Value Through the use of minimum rate of return referred to as hurdle rate, net present value of a given investment is defined as the present value of cash outflows. It is commonly expressed as the Present Value of the Benefits (PVB) less the present value of cash costs (PVC). NPV=PVB-PVC By the use of hurdle rate perceived as discount rate, a test is conducted to assess whether or not the project will earn the desired minimum rate of return. This implies that when NPV is positive the benefits are more and enough to repay a company for the cost of assets and financing a project as well as a rate of return which adequately compensates a company for any risks established in cash flow estimates. With zero NPV it indicates that the benefits are enough to cover all the three costs, though, one has to breakeven hence not able to accept the project. Negative NPV shows that benefits are not enough to cater for all the three costs, and thus a project should be rejected. 2. Internal Rate of Return Internal Rate of Return (IRR) is considered as the rate of return on which an investor expects to earn on any investment. Technically, IRR is perceived to be the discount rate which causes the present value of benefits to be equal to the present value of costs. It is the most commonly applied method in the evaluation of capital budgeting proposals. In comparing NPV with IRR, NPV is considerably better than IRR because with net present value reinvestment of the cash flow can be easily made. This is because NPV method assumes that the cash flow of a project is already reinvested purposely to earn hurdle rate which is a different case with IRR. Thus, the NPV assumption considered more realistic in various situations than IRR which seems to be very high certain projects. However, IRR can possibly have multiple solutions in terms of cash flow estimates. Advantages and disadvantages of Capital Budgeting Capital budgeting summarizes the entire capital planning activities within a consistent format so as to prioritize the projects and programs undertaken, coordinate activities as well as budget resources. It also develops a more centralized methodology that efficiently manages the capital projects across the multiple department and sites of an organization. Capital budgeting enables the “what if” planning in order to minimize the business interruption and the cost overruns. Additionally, it integrates the condition assessment and project management functions to efficiently allocate both budget and resources for a complete end-to-end planning of an organization. Access to the defensible capital budgeting information is important in reducing the risks associated with undertaking time-consuming and expensive projects that ultimately fail because of inadequate resources. For example, the application of ARCHIBUS Capital Budgeting offers the best method in tracking the capital budget cycle based on request and evaluation, approval as well as funding (Rye & Hickman, 1997). Therefore, with such information within a single and centralized location, majority of the users are able to execute the master planning, modernize, expand and consolidate their projects in a cost-effective and organized manner as illustrated above. Users can as well easily generate a visual representation of their planned budgets order by the spending category so as to justify their capital requests. In summary, capital budgeting both in theory and practice provides the business managers with the knowledge, advice and insight that will permit them to handle one of the critical aspects of own financial management of a firm. Although it is more advanced for the practitioners, it is accessible enough for the beginners. It is also a complete guide to both understanding and benefiting from the essential techniques used in capital budgeting (Pamela & Fabozzi, 2002). The main drawback of capital budgeting process lies within the verity which entails a number of estimations such as cash outflow, life of projects and revenue or saving as well as costs attached with projects. Other limitations include, capital budgeting has long-term implementations that cannot be applied in the short-run and yet it determines the operations of the business. This implies that wrong decisions within its early stages can have an effect on the long-term survival of a company. Therefore, the operating costs increase if investment of the fixed assets gets more that is required. Inadequate investment always makes it more difficult for a company to increase its budget and capital. Additionally, capital budgeting requires large amount of funds, thus the decision taken has to be careful and the decisions made within capital budgeting cannot be modified because it is not easy to locate the really market for capital goods (Sidney & Peter, 2006). Conclusion Capital budgeting is a critical part in the financial management of today’s firms. The main techniques used in the capital budgeting incorporate the accounting rate of return, profitability index, and internal rate of return, modified internal rate of return, net present value, cost-benefit analysis, real choice method and equivalent annuity. Such techniques assist firms in their task of best allocation of the resources. Time value of money sets out the various factors that are significant in investing and is also part of the firm’s opportunity cost that guides the decision maker on whether or not to invest on a given capital good. Decisions made in capital budgeting are very vital for a firm despite the complexity nature of the process involved. The ability to understand the classification of capital budgeting within projects plays a vital role in analyzing the viability of such projects. References Dayananda, D., (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press. Droms, W., (1997). Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know, Perseus Books. Emery, D.R., Finnerty, J.D & Stowe, J.D., (1998). Principles of Financial Management. Upper Saddle River, NJ: Prentice Hall. Harvey, A., (2005). Capital Budgeting Decisions: A survey of Latin American Practices, in Harvey Arbelaez and Reid William Click (ed.) Latin American Financial Markets: Developments in Financial Innovations (International Finance Review. Emerald Group Publishing Limited. 5, 45-61 Kent Baker, H., (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects, An essential guide to valuation techniques and financial analysis. John Wiley and Sons. Levy, H., & Marshall, S., (1994). Capital Investment and Financial Decisions. 5th ed. New York: Prentice Hall. Pamela, P and Fabozzi, J.F, (2002).Capital Budgeting: Theory and Practice. John Wiley and Sons. Pinches, G.E., (1996). Essentials of Financial Management. 5th ed. New York: HarperCollins. Rye, D.E. & Hickman, C.R. (1997). Starting up: an interactive adventure that challenges your entrepreneurial skills. Paramus. Prentice Hall. Sidney, W & Peter, O., (2006). A commentary on “Why DCF capital budgeting is bad for business and why business schools should stop teaching it.” Accounting Education. 15(1), 25-28. Scott, D.et al. (1999). Basic Financial Management. Upper Saddle River, NJ: Prentice Hall. Read More