CAPITAL BUDGETING 6
Capitalbudgeting is the financial management practice of determining theworthiness of funding or investing in long term investments based ontheir returns. It is a tool of management that is applied to makeinvestment decisions based on the cash inflows that differentinvestments have to the investor and in comparison to the cashoutflows of the investments. According to Cooper et al (2001), it isa tool is applied in the evaluation of long term investment projectsby a firm with a view to recommending the projects that have value tothe firm as well as to the shareholders. Some of the projects includenew plants, buying new assets, new product lines, new machinery orfinancial investments.
Thefirst stage of capital budgeting is the identification of theprojects that a company is seeking to invest in. According toDayanandaet al (2002), this stage involves discussion and consultation withinthe departments of an organization so that all the information aboutthe identified projects is discussed. For instance, the marketenvironment projections are discussed with the marketing departmentwhile the costing environments of various projects are consulted fromthe management accounting department (Hirschey,2008).At this stage, the management also discusses the process and appointsa competent capital budgeting, team, or decides to outsource theprocess to a team of experts. With the information gathered in thediscussion and consultation within the organization, the details arepresented to the capital budgeting team.
Thesecond state is the estimation of the cost of the projects that aremost promising for the organization. This stage involves specific andquantitative estimations that are expected from each of the projectsunder consideration (Hirschey,2008).For each project, the cost outlay is determined and the operationcosts estimated so that the total cash outflow is determined.According to Dow(2009)this stage involves specific inquiries for the expenses of everyproject that the firm is evaluating. For instance, an expectedevaluation of new machinery will involve inquiries from expertengineers. At the same time, this stage involves the confirmation ofthe estimated costs and expenses by the accounting departments. Thisis an important control measure to ensure the accuracy andcorrectness of the figures used, so that the process can be authenticand reliable.
Thethird stage is the estimation of the expected cash inflows that areexpected from the projects that the firm is appraising. Thedetermination of the expected cash inflows involves estimation ofspecific cash returns at specific dates (Dayanandaet al, 2002). This stage also determines the specific lifetime ofevery project under valuation. This is because the capital budgetingprocess will utilize the periodical cash inflows from the projects sothat their value can be calculated (Cooper et al, 2001). AccordingtoDow (2009), thisis important because it determines the frequency and the amountexpected for every period of cash inflow. For instance, a projectmight generate more cash flow at the beginning than at the end, whileanother might generate more cash flow at the end than at thebeginning, or evenly during the operational lifetime.
Thefourth stage is the calculation stage. Armed with the figures of thecost outlay and the cash inflows for every project, this stageinvolves the application of the selected techniques of capitalbudgeting (Damodaran,N.d).Some of the most common techniques include the Net present value, theAccounting rate of return, the Internal rate of return the Paybackperiod and the Profitability index (Hirschey,2008).These techniques are aimed at evaluating each of the projectsindependently and appraise the value that each brings to theorganization. For instance, the Net present value (NPV) method valuesthe projects by comparing the present value of cost outlay with thepresent value of the cash inflows.
Thefinal stage is the decision making stage where the informationderived from the capital budgeting process is appraised andevaluated. This is the financial management stage where the estimatesand value of each project is scrutinized against the businessenvironment to determine the success or the failure of the projects(Hirschey,2008).According to According to Dayanandaet al (2002), the decision is made based on the company’sprinciples that guide their risk taking and worthiness of projects.The company will make a decision based on the level of risk they areready to take and for what level of worth they are expected to investin a project.
Oneof the advantages of capital budgeting is the ability to valueprojects based on the current time value of money. According toCooper et al (2001), the process recognizes the effect of time onmoney, and so uses present value of money to determine the real valueof each of the projects. In addition, capital budgeting isadvantageous to an organization because it helps in making strategicdecisions about long term projects that have a heavy financial costoutlay for the firm (Damodaran,N.d).Moreover, capital budgeting considers the significance that theprojects have on the company’s financial structure, by evaluatingtheir cash inflows against cash outflows of each project.
Disadvantagesof capital budgeting
Oneof the main disadvantages of capital budgeting is that the process istedious and time consuming. This lengthens the time taken by themanagement to make decisions regarding the investment in long termprojects (Brunner,n.d).Therefore the process has a disadvantage of not fitting for projectsthat require extremely urgent decisions. Moreover, the capitalbudgeting process requires specialized accounting expertise andknowledge that may not be available within the professionals in afirm. Therefore, outsourcing this expertise by an organization makesthe process expensive for the management.
Using to help a Company
Managerscan use capital budgeting to help a company in two main ways. First,they can use the process to guide the firm in investing in the mostvaluable long term projects that have higher cash inflows. Accordingto Dayanandaet al (2002), this will increase the profitability of the company andimprove its value and that of its shares. Secondly, managers can usecapital budgeting to prevent the company from making loss by closingoperations or products that are not valuable. Through capitalbudgeting, managers can determine the costly projects that lead tolosses to the company, and make the decision to drop them from thecompany’s portfolio.
Capitalbudgeting is the management tool for determining the most valuableproject for a company to invest in through the use of financialtechniques. The process involves five main stages that involveproject determination, cost estimation, cash inflow determination,discounted calculations and decision making. The process isadvantageous for making decisions based on present valuations ofprojects and consideration of a firm’s capital structure. However,the process is generally viewed as time consuming and requiresexpensive expertise. Capital budgeting can be used by managers todetermine the valuable projects of products for a company anddetermine which projects of products that a company can close basedon the value they return. Such decisions make animportant tool for financial management.
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Hirschey,M. (2008). ManagerialEconomics. Stamford:Cengage Learning
Damodaran,A. (N.d). TheInvestment Principle.Retrieved From, Stern School of Business,<http://people.stern.nyu.edu/adamodar/pdfiles/country/invanal.ppt> April 21, 2015
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