The decisions that the management makes regarding capital investment and financial management determines the success of any corporation. In essence, the management should make the investment, financing, and dividend decisions carefully to facilitate the maximization of the shareholders’ wealth. Ideally, sound investment decisions ensure that the firm utilizes the existing investment opportunities well. Additionally, sound financing decisions make sure that the firm has necessary sources of fund to use in its investments. What is more, sound dividend decisions ensure that the company retains enough earnings to distribute to the shareholders or use in future investments. The decisions about the firm’s investment in its long-term assets ought to be sound to guarantee the success of the future operations. Capital budgeting is one of the crucial managerial tools that a firm uses to determine whether the benefits of investing in a project will outweigh the costs. According to Brijlal (2008), capital budgeting plays a central role in the financial management role of any organization. It involves evaluating the investments opportunities of business and deciding the ones to accept. For this reason, the present paper delves into the topic of capital budgeting. In particular, the paper elucidates the process of capital budgeting, the techniques used in capital budgeting, and the importance of capital budgeting in business.
Capital Budgeting Process
In any business, anyone including the suppliers, workers, suppliers, among other stakeholders can generate the investment decisions. There are various factors that influence the investment decisions of a company. Among these factors include the demand forecast, fiscal policies, business rival’s strategy, technological changes, management outlook, cash flow, and a firm’s expected returns from its investments. Different questions regarding the investment decisions arise after the generation of ideas. One of these issues entails the amount of money that the business will require for the upcoming expenditures. The other question entails the amount of money available to the company. The third issue involves the amount of money that the business will need to raise to implement the projects. The process of capital budgeting begins with the examination of numerous investment opportunities. The management of a corporation compiles a list of possible investment projects and estimates their future consequences to the corporation through a process called cash flows estimation.
The other step involves assessing the riskiness of project’s cash flows. The business reviews the risks that are connected to the project. Examining the risks of an investment project help to determine whether the suitable necessary rate of return is used to calculate the net present value of a project (Peterson & Fabozzi, 2002). The risks identified during project evaluation include the corporate risk, stand-alone risk, and market risk. The corporate risk determines how a company’s investment project is associated with its current assets. The stand-alone risk is calculated through the use of scenario analysis and sensitivity analysis to determine the dangers related to investing in a particular project. The market risk is computed to determine the likelihood of a business to experience losses as a result of factors, which affect the financial finance markets. The next steps involve determining the suitable discount rate and finding the present value of the anticipated cash flows. The investment project is accepted if its present value of inflows is more than costs.
Capital Budgeting Techniques
Businesses use different methods to make decisions about investment. They use both qualitative and quantitative analyzes to evaluate projects. The various capital budgeting techniques that managers use include net present value, payback period, internal rate of return, profitability index, accounting rate of return and discounted payback period as below described.
Net Present Value Technique
The net present value (NPV) technique is one of the best capital budgeting methods used by businesses. The management uses this technique to determine the investments that add value to the corporation. Those investments that have positive net present value are selected because they add value to the business and increase the shareholders’ wealth. It considers cash flows and timing. Net present value is calculated by getting the difference between the present value of a firm’s benefits and the present value of its costs (Rajah, 2005). One of the advantages of NPV is that it informs the management whether the investment will add any value to the company and, as a result, helps in maximizing its value. Additionally, the net present value technique is also beneficial because it considers the forthcoming cash flow risks, time value of money, and all the cash flows. Moreover, net present value method of capital budgeting gives the firm’s risk and profitability a high priority. However, net present value technique might not provide the suitable decision when the company’s project is of unequal life. The other disadvantage of net present value is that it is not expressed as a percentage.
Payback period Technique
The payback period method of capital budgeting involves calculating how long it will take for a company to recover its initial invested cash. Unlike the net present value technique, the payback period technique does not consider the cash flow present values. When using this technique, the management rejects or accepts an investment project on the basis of its payback period. An investment payback period functions as a vital defining factor in whether a business will invest or not. The investments that have short payback times are selected because they are more rewarding, implying that the projects with the fastest payback are chosen. One of the advantages of payback period technique is that it is simple to compute. In essence, this method is easy to use and comprehend for most people. Additionally, the payback period method offers a crude liquidity measure. Moreover, the payback period technique offers useful information on the risks involved in an investment. However, the payback period method ignores future cash flow risks, time value of money, and the cash flow past the payback period as suggested by Peterson & Fabozzi (2002). The payback period method does not offer reliable decision about whether an investment project will increase the value of the company.
Internal rate of return Technique
The internal rate of return method of capital budgeting is used to assess the desirability of investment projects. A project with a high internal rate of return is selected because its profitability is presumed to be high (Peterson & Fabozzi, 2002). In essence, the internal rate of return indicates the cost effectiveness, quality, and efficiency of a project to be undertaken. The businesses use this capital budgeting technique to compare the profitability of different investments. Internal rate of return method is important because it indicates the return on the initial cash invested and, as a result, help to determine if an undertaken investment will increase the value of a business. Just like the net present value technique, the internal rate of return method also considers the forthcoming cash flow risks, time value of money, and total cash flows. Nevertheless, a business using the internal rate of return cannot make a decision without first estimating the cost of capital. Additionally, the internal rate of return is not applicable to the conditions in which the project’s cash flow signs change more than once in its life. What’s more, this method might not provide the business with value maximizing decisions when it uses it to compare the projects that are mutually exclusive.
Accounting rate of return Technique
The companies use the accounting rate of return method to compare the profits that they anticipate making from different investment projects to the cash they are required to invest. According to Rajah (2005), the accounting rate of return takes into account the profitability of a project. The accounting rate of return technique makes use of the accounting profits that the firms anticipate arising from their investments over their expected lifespan. An investment project that has a high rate of return is selected. It is easy to comprehend the accounting rate of return. Nevertheless, there are numerous problems associated with this method. Firstly, the accounting rate of return technique fails to indicate whether the investment of a company will have an impact on its operations’ throughput. Additionally, this capital budgeting technique fails to disclose the return on the real cash flows that a business experiences as it comprises non-cash expenses. The accounting rate of return method is also not suitable for comparing different projects. Compared to the other capital budgeting techniques, the accounting rate of return is the least suitable technique of evaluating a project.
Discounted payback period Technique
The business use the discounted payback period method to determine the project’s profitability. Ideally, this technique gives the period it takes for a business to break even from executing the first expenditure. The businesses compare their investment project against the investment costs. It is worth noting that the discounted payback period method of capital budgeting considers the time value of money. Additionally, this technique gives business owners a good estimate of the payback period. The discounted payback period also considers project’s cash flow riskiness. However, this technique demands the businesses to approximate the cost of capital so as to compute the payback. Moreover, this technique does not consider the cash flows that are past the discounted payback time.
Profitability Index Technique
As its name suggests, the profitability index technique of capital budgeting helps the businesses assess projects for their profitability. The businesses using this method first calculate the anticipated cash flows of the investment project. The second step involves finding the investment project’s cash outflows. The businesses then choose a suitable discount rate and uses it to discount the anticipated cash inflows. The other step involves discounting the upcoming cash outflows and adding to the original investment. In the last step, the discounted anticipated cash inflows are divided by the discounted upcoming cash outflows. Peterson & Fabozzi (2002) implies that the projects with a profitability index that total or are greater than one are selected. One of the benefits of profitability index technique, when used by businesses, is that it determines whether an investment project will raise the value of the firm. The technique is also very beneficial in ranking, as well as, choosing the investment projects when resources are rationed. The profitability index method also considers the forthcoming cash flow risks, time value of money and all the cash flows just like the net present value and internal rate of return. Nevertheless, the profitability index just like the internal rate of return might not provide a business the suitable decision when it is applied in comparing the projects that are mutually exclusive.
The Importance of Capital Budgeting
Capital budgeting decisions are the riskiest and hard decisions made in a company. For this reason, managers should be careful when making these decisions. A careful analysis of capital budgeting decisions brings forth numerous benefits to a business. For one, capital budgeting facilitates sound decision-making. With the help of capital budgeting, the managers take the needed steps to analyze the investment opportunities of a company and come up with the best option. In essence, a company that uses capital budgeting generates decision rules that help in categorizing the acceptable and unacceptable projects and, as a result, saves resources and time. Additionally, capital budgeting generates measurability and accountability in business. A business that uses capital budgeting as a decision tool measures the effectiveness of its investment decision easily. Capital budgeting also helps the managers understand the returns and risks associated with a project.
The development and formulation of long-term strategic goals of a company become possible with the help of capital budgeting. In particular, capital budgeting helps a business evaluate different investment projects. Consequently, this generates a framework for such a company to plan out its lasting direction. Capital budgeting is also important because it helps businesses forecast and estimate their future cash flows. Furthermore, the capital budgeting process helps businesses control and monitor their expenditures. Capital budgeting is also a distinctive risk-assessment and decision-making tool for companies. With the help of capital budgeting, businesses review possible investment projects objectively and individually. Ideally, capital budgeting helps a company determine whether its projects or investments will add value. It is worth top note that capital budgeting facilitates the determination of risks involved in a project or investment.
Brijlal, P. (2008, August). The use of capital budgeting techniques in businesses: A perspective from the Western Cape. In 21st Australasian Finance and Banking Conference.
Peterson, P. P., & Fabozzi, F. J. (2002). Capital budgeting: theory and practice (Vol. 10). John Wiley & Sons.
Rajah, H. J. (2005). Impact Of Investment Types And Firm Characteristics On Capital Budgeting Techniques (Doctoral dissertation, USM).