Capital Budgeting Decisions - Literature review Example

Capital Budgeting Decisions Name Professor’s Name Course name Date Capital Budgeting Decisions One of the most important decisions a company can make which might have huge impacts is capital budgeting decisions (Danielson & Scott, 2006). It has been argued that a capital budgeting decision can be used to illustrate an investment decision with long-term effects. During capital budgeting, an organization focuses more on the flow of cash and not the earnings made by an organization. Several researchers have established three ways in which investments can be ranked which include payback, the internal return of rates and the present value of the net. In establishing the capital budgeting decision, it should be remembered that the cost of the capital is represented by the cutoff rates. In addition, it is only responsible that during capital budgeting decision, should be analyzed after all taxes have been levied. This paper will delve into capital budgeting decision. According to Peterson and Fabozzi (2004), capital budgeting has eight main areas that may prove to be a complex when needed for derivation. The areas are broad and very essential for consideration by any organization willing to conduct capital budgeting. Administrative considerations When an organization has established an excellent capital program, the administration must ensure that all the steps included in decision-making are relevant. The first approach is the seek for lucrative or promising investment opportunities preferably in line with company’s specialization. The next step would be to gather primary and secondary data that is reliable and valid. Evaluation of collected data can be used by the relevant authorities to come up with informed decisions (Bierman and Smidt, 2014). It will also be necessary for the administration to re-evaluate the performance of the budget and make correction or recommendation where necessary. Accounting versus cash flows Most capital budgeting decisions have placed more attention on cash flow and not income flow as recommended (Baker and English, 2011). When using cash flow in capital decision making. When using cash flow as the major factor for capital budgeting process, other factors such as depreciation and actual expenditure will not be reflected well in the capital budget. The aspect of depreciation must be considered as a firm might make a profit before depreciation, and the profit cannot directly be used for the purpose of capital budgeting. Therefore, one can realize that the most important factor in capital budgeting is understood the trend of cash flow as well as the trend in income flow. Payback method and internal rate of return are the other two aspects that capital budget must incorporate enough study must reveal the time that, and investment is expected to bring back the initial investment (Danielson and Scott, 2006). The most convenient payback option may provide budget planners with a clear idea of the project that is superior. Most US corporations have used the ‘payback’ period strategy to identify the best investments to venture. Theoretically, correct methods must be employed when calculating the payback period of a specific investment. Analysts will always find it financially prudent to use internal rate of return to estimate the trend of cash flow once a project has been implemented. The procedure involves calculating the interest rates expected to be earned from a project. Cash flow analysis and selection Analysts have to derive a way in which they can be able to study the broad pattern of cash flow within an organization (Bierman and Smidt, 2014). The knowledge of such cash flow is technically the entire picture of the financial behavior of the organization. Therefore, the firm has to consider some accepted depreciations that might affect the investment. Tax rates within the economy must be well studied to establish the trend in which the rates have been changing over years. Capital budgeting assumptions for small organization The theory for capital budgeting considers several assumptions with the main one indicating that the primary goal is to increase the value of the organization (Peterson and Fabozzi, 2004). Another assumption made when budgeting is that these small firms have good access to the existing financial markets hence can finance any intended project. These assumptions require firms to treat two factors separately in a way that investment and financial decisions are met separately. Analysts should consider the fact that small firms may not be out to enhance the value of shareholder as large firms may do. Therefore, the growth of a firm may not necessarily imply that it is an intention to realize growth in value. Most of the small firms may not have adequate resources in the field of financial accounting hence the use of cash flows may not apply. Importance of capital budgeting to Saudi Arabian Firms According to Baker and English (2011), firms stand a high chance of developing long-term decisions that can propel a firm to a higher level. Such a benefit is capable of reducing the possible financial risks especially under unpredictable economic situations such as the recession. A lot of funds are used for capital budgeting. Thus, less money is wasted on projects or activities that have little to promise for the future. Most organizations can benefit from capital decisions to avoid future uncertainties. Firms must be aware that in a case of analysts fail to predict correctly a financial situation; a firm can either spend more or less on a project. The irreversibility nature of capital budgeting decisions thus implies that the firms must use competent analysts for the work. When this is done, firms can be sure of allocating the correct resources in an efficient manner that would pay back with time. firms may fail in capital budgeting due to poor financial capacity to fund capital projects. Conclusion One of the major decisions firms can make the capital budgeting decisions, which has been discussed in this paper. These kinds of decisions have been cited as being capable of overcoming uncertain economic trends such as a recession. Larger firms have been identified to have the adequate financial capacity to hire competent analysts to predict the future and advice on the best capital projects a firm has to invest. On the other hand, the small firms may lack such funds and even lack funds to fund capital projects. Capital projects are very important in the long run as a firm stands a chance to experience growth across its investment sectors. References Baker, K., & English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. New York: John Wiley & Sons. Bierman, H., & Smidt, S. (2014). Advanced Capital Budgeting: Refinements in the Economic Analysis of Investment Projects. Routledge: London. Danielson, M., & Scott, J. (2006). The Capital Budgetting Decsions of Small Businesses. Retrieved from Haub School of Business: http://astro.temple.edu/~scottjon/documents/CapitalBudgetinginSmallFirms_June2006_final.pdf Peterson, P., & Fabozzi, F. (2004). Capital Budgeting: Theory and Practice. New York: John Wliley & Sons. Read More