Essay Sample on Capital Budgeting

Published: 2021-07-16
1793 words
7 pages
15 min to read
Harvey Mudd College
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Businesses determine and evaluate the potential capital investments through capital budgeting techniques. In most cases, a projects outflows and inflows are measured to determine whether its returns meet the estimated capital investment targets of returns, i.e. investment appraisal. The management of the businesses identify the investments that would improve the companies competitive advantage and shareholder wealth. Usually, the capital budgeting process focus on fundamental principles that are also important in the allocation of money. An operating budgeting process is a budgetary program by health care organizations that anticipate the day to day activities of the organization. An operating budget accounts for daily resources, personnel and supplies required in a hospital. An operating budgetary process lasts basically for over one year and includes flexible estimates for the cost of expenses in relation to the expected revenue (Bernado, 2001).

The implementation of a capital budget plan should be determined by a possible positive time value of money and also consider the risks of undertaking such investment. The capital budgeting should focus on the cash flows which are easier to forecast and calculate rather than profits based on the various aspects such as the operating income, revenue, and deductions (expenses). When a business focuses on profits during capital budgeting, it only gets conservative estimations while a focus on the cash flows would give it the best estimates that consider the risks of the capital investment projects. The budgeting process is the process through which organizations prepare for a budget on their activities and running organization projects. Budgets are estimates of the required financial resources for organization activities; budgets are made by the financial department. However, there is the need for significant cooperation in the organization departments during the preparation of a budget. Budgeting process involves all the departments and management as well as the strategic goals of the organization. Organizations prepare budgets to set expectations regarding their revenues and expenditures within a given period of time. The cash flows represent cash which the company can reinvest and attain liquidity. If the cash flows ignored in the capital budgeting, the company may lose liquidity in those projects when implemented. When the cash flows are ignored, the projects costs and other risks might undermine the companys profitability and affect the overall value of the firm (Brata, 2014).

Incremental cash flows represent the changes in cash flow that the project would have on the company. The relevant cash flows are considered before the actual evaluation of the capital budget plan. The aspects that affect the capital budgeting include sunk costs and externalities of the projects. Sunk costs are the costs that are already incurred whether the projects are accepted or not. These costs are unrecoverable and should be ignored since they do not affect the capital budgeting decisions in any way. In addition to sunk costs, other intangible costs and benefits are avoided. Externalities of the projects should also be considered in the evaluation of the investment plan. These refer to the effects that the new project would have on the existing cash flows and operations of the firm if it is implemented. When this principle is ignored, negative externality, also known as cannibalization, can have a detrimental effect on the existing business operations. The business might also incur opportunity costs, i.e. the costs of not implementing the project or cash flow not earned as a result of the business utilizing its assets for other projects (Bernado, 2001).

One of the major challenges that affect financial manager in any organization is making capital budgeting decisions. Financial manager must select capital budgeting projects that maximize the value of shareholders. This goal is achieved by employing capital budgeting techniques such as net present value, internal rate of return, discounted payback, payback and time adjusted discounting. Financial managers use these techniques to evaluate whether a project will create value for their shareholders. According to Paseda, financial managers consider additional complex techniques when evaluating projects that have the higher level of risk and uncertainty (3). However, the survey noted that there is increased the prominence of the net present value as the most preferred technique of project appraisal in capital budgeting. This argument is supported by Bernardo, Cai and Luo the net present value allow managers to identify whether a project will generate positive or negative cash flow (313). The likelihood of using net present value as the most preferred evaluation technique depends on three factors including firm leverage level, CEO characteristic and the size of a firm. If managers discover that there are high risk and uncertainty in a project, it is recommended that they should use real options because there facilitate the linkage between corporate strategy and financial objectives of business in the ever increasing complex business environment.

According to Batra and Verma, capital budgeting literature has focused on bringing to light the neglected areas that modern researchers should focus in capital budgeting (341). According to this literature, project definition, implementation and review are the most neglected stages in capital budgeting. A study conducted in Indian companies suggested that the overall stages of capital budgeting including implementation and review remain unexplored. Present studies should focus on exploring the opinions and perceptions of different stages of capital budgeting in India. Studies have shown that globalization has increased competition, which has increased the degree of risk during project implementation (Graham & Harvey 13-15).

As noted by Zubairi, domestic and international companies in Pakistan are well aware of practical sophistical capital budgeting techniques when faced with risk and uncertainty (1). This study established that big companies use internal rate of return as their preferred capital budgeting appraisal technique while small companies prefer net present value. Moreover, some small companies in Karachi prefer payback period than large companies because it is easy to use. However, the study found that firms with large proportional of their capital finance from debt prefer to employ net present value while low growth and leverage firm employ internal rate of return (Jacobs 2). This is an indicator that the net present value is the most preferred capital budgeting appraisal technique. Apart from NPV and IRR, the analyst can use the average cost of capital, equity residue method and adjust the present value. A companys Net Present Value refers to the amount that is the total of all project cash outflows and inflows that have been discounted back to the present value. While calculating the Internal Rate of Return of an asset, much consideration should be given to bringing the net present value to zero. By definition, the Internal Rate of Return refers to the profitability amount used by companies to yield the greatest return per dollar of it capital investment such as assets purchased. Basically, a businesses IRR reflects the expected gains in percentage form of the initial investment. The method employed depends on the level of risk and leverage level of the firm (Jacobs 5). Pierru and Babusiaux concluded that the most widely used technique among WACC, equity residue method and adjusted present value is the weighted average cost of capital (3). The WACC is preferred because it allows managers to separately consider investment decisions of a firm and its source of capital. High leverage firm uses WACC because it assumes that the debt used to finance the project satisfied target debt ratio concerning project value. Due to disparities in tax rate treatment and interest rates, it is essential for multinational companies to seek optional allocation of debt in various projects to maximize shareholders value as they reduce risk.

Cornel elucidated that the leading financial textbook has agreed that discounted free cash flow is the most preferred capital budgeting appraisal technique (1). This technique allows project managers to use different discounting rates to evaluate different projects. However, Cornell feels that this benefit is detrimental to firm for two reasons (4). First, the betas of a project are measured with significant error, which tends to change over the life of a capital budgeting project. Secondly, using different discounting rate conflict, the general equilibrium of management goal in ensuring a business achieved a successful corporate culture in innovation. Therefore, the only firm that achieves equilibrium in project management will achieve greater performance based pay because it discourages managers to overstate project quality. Therefore, when determining performance based pay, it is essential to note that greater performance based pay does not equal to higher quality project cash flow.

According to Kim (2006), capital budgeting decisions require the acquisition of information to become relevant (261). If the cost of acquiring information is small, the optimal capital budgeting is assumed to be routine appraisal where managers have all the information they need to make sound investment decisions. If a firm decides to offer the incentive to acquire information, there is a high probability, the information acquired for capital budgeting decision will be bias or distorted because there is more intensive auditing. When acquiring information cost is high, the optimal capital budgeting differs from routine projects. If the firm decides to offer more incentive to acquire information, auditing becomes intensive, and the project that creates value is allocated capital.

Jan Jacob argued that the net present value and internal rate of return are the most preferred capital budgeting appraisal techniques (Jacobs 4). However, these techniques are prone to misinterpretation when net present value rank projects in absolute terms. There are instances where net present value and internal rate of return rank projects in a conflicting manner due to timing differences size of mutually exclusive projects and disparities in discounting factors. The differences between the two methods are mathematical calculations, but in economic terms, both techniques use discounted cash flow method to evaluate capital budgeting project.

The cost allocation for capital budgeting frequently requires coordination between different divisions of a firm. To ensure department is accountable for their own decisions, cost allocation in capital budgeting is tied to a cost allocation system to determine whether the project is acceptable or not by allocating depreciation and capital charges. If the investment project relates to a common asset, then the central office attaches a sharing rule among users. Capital costs allocated to each project are based on a hurdle rate, which is determined by the divisional report. As noted by Baldenius, Dutta, and Reichelstein, this hurdle rate deviates from the cost of capital depending on whether there is coordination challenge in the common asset or competing projects (838). The author noted that divisional agency problems increase hurdle rate for common assets, which is not true for competing projects. Capital budgeting projects are marked by large business corporations with a lead time that goes more than a year before the entity expects a return on investment. The inherent risk factors that are associated by a high number of long-term investments tend to increase the riskiness of a capital budgeting project. Although the managemen...

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