Discuss about the Capital Budgeting Process and Decision.
For any company, success is determined by capital budgeting decisions. This is one of the decisive factors for the failure or success of a company. Financial managers are tasked with perhaps some of the most important decisions that affect the business (Capital Budgeting Valuation, 2013). However, it is important to note that there are several factors that combine to make decisions in capital budgeting these decisions continue for a number of years, thus, the decision makers or the managers are part of this flexible process. Since capital assets must be used when needed, then this makes opportunity a very important consideration in the capital budget. Capital budgeting process is important because expansion of assets implies very large expenditure. Before a company uses a very large amount of money on a project the managers should ensure that the company has sufficient available funds to finance the entire project. Two examples of capital budget decisions (Donovan, 2006).
Information required within the firm may vary in accordance to the level of organizational structure. Senior executives or CEOs decisions are structured less in the sense that there are no situations that are repetitive and subsequently no single solution can be applied; On the other hand, evaluation and assessment criteria and points of view should be known for each situation where the data is accurate and must come from subjective and external in uncertain and risky environments. Since it is not possible to determine and control all the variables or factors that affect a situation, it is that models are sought to represent reality for their analysis in the hope that those decisions made are satisfactory and not optimal decisions within the context of rationality of who They must make decisions (Kalyebara, & Islam, n.d.) . Specific and concrete at each level to the lowest levels. The information required in all these decisions represents the point of departure for carrying out actions that will ultimately affect the performance of the organization
Capital Structure of the Company The optimal capital structure is that for which the cost of capital is minimal: if the company is financed with this debt / equity ratio, the market value of the company will be maximum. Optimal financing structure e = Debt / Own Resources in practice is difficult to determine. Generally speaking, financing projects whose economic profitability exceeds the cost of the project itself will increase the shareholder’s profitability in that difference (depending on the margin between the investment return and the cost of the debt). : It is necessary to see the project independently of the rest of the projects of the company. This approach, however, considers only the explicit cost of debt, that is to say, the derivative of comparing the revenues and disbursements originated by indebtedness.
There are other costs apart from the explicit so that it diminishes the profitability of that project or even that it is negative. But the ability to borrow is not unlimited because if we borrow now, we will have to opt for more expensive debt or own financing in the future (Rasmussen, 2003). Therefore, the debt has an implicit cost: to finance itself today with debt, may mean having to give it up in the future. This is related to the formulation of the capital budget according to which the financing of a project has to be studied within the framework of the general and future situation of the company. That is why we speak of the weighted average cost of capital at the time of comparing with the profitability of a project: the project has to be taken into account as integrated into the company and not in isolation. You have to collect all the debts of the company and find the weighted average cost to match.
Capital Budget is a tool used to carry out certain cost planning processes for companies, families, businesses, among others, which would produce certain economic benefits with terms stipulated within a year.
The capital budget can also be defined as a valued list of projects which may be feasible for the acquisition of new economic benefits, that is to say, for example, when a company makes a capital investment it incurs the current cash outflow and this Expected future benefits, the benefits usually extend for more than a year (Vogt, 2004).
Within the Capital budget we can find the following advantages:
It supports the development of the procedure and / or purpose.
It promotes interaction, communication and help between the areas of the company.
They give common sense when making investment proposals.
They serve to evaluate and choose a referential point of view.
Within the capital budget we can also find the following disadvantages:
It does not recognize the value of money over time.
Your money recovery process is much slower than agreed.
The way the parameter is set against which the recovery period of each project is compared to arrive at a decision (Shah, 2007).The fact that this method has these disadvantages does not mean that one should avoid its use in any circumstance that requires it, this means that they must be taken into account in order to make the best decision.
The budget brings a number of advantages to the organization, being a planning tool. They include;
The working capital of a company is what allows it to develop its social object, and of the administration that is made of it, it depends that the company grows at a greater or lesser speed, or in the worst case, that its assets are diminished or it leads to the definitive bankruptcy of the company(Nice, 2002). In such a way that the working capital is the basis on which the operation of a company is supported, which is why the importance of its administration will be exposed in this essay, the decisive and definitive one that can be in a business to manage and Budget correctly.
Most capital budget studies focus on the problems of calculation, analysis and interpretation of risk. One of the most important tasks in preparing a capital budget is to estimate the future cash flows for a project. The forecasts for these are based on estimates of incremental revenues and costs associated with the project (Hornstein, & Yeung, 2005).
In each investment proposal it is necessary to provide information on the expected future cash flows after taxes. For example, if a company is considering launching a new product that will compete with existing ones, it is not appropriate to express their cash flows based on their estimated sales. It is necessary to take into account the possible “affectation” of existing products; therefore, the estimation of cash flows should be made based on incremental sales. The key is to analyze the situation with the new investment and without it.The most important are incremental cash flows(Nice, 2002).
The “sunk” costs should be omitted, the focus is on incremental costs and benefits; the recovery of past costs is of no importance to the project.. It is also important to note that certain costs do not necessarily mean a disbursement of money; it will be necessary to include the opportunity cost in the valuation of the project.
The most important application of the cost of capital is the capital budget, in addition to serving to determine the decision or to buy or lease, for the repayment of bonds and in decisions to use debts or stockholders’ equity.
It is possible to fully fund a company with equity funds, which must be equal to the required return on the stockholders’ equity of the company, and must consider their cost of capital from various sources of long-term funds (preferred shares or debt In the long term) and not only the stockholders’ equity of the company..
The weighted average cost of capital is calculated as a compound value, made up of the various types of funds you will use, regardless of the specific financing for a project.
Capital components are the type of capital companies use to raise funds (debts, preferred shares and common stockholders’ equity), any increase in assets is reflected in any of these capital components.
The cost of post-tax debt is the interest rate on new debt and is used to calculate the weighted average cost of capital (Baker, & English, 2011).
Costs components of debt after tax = interest rate – tax savings (interest is deductible), is used because the value of the shares depends on the cash flows after tax.
The component cost of preferred shares is also used to calculate the weighted average cost of capital; it is the rate of return that investors require and is equal to dividing the preferred dividend.
References
Baker, H., & English, P. (2011). Capital Budgeting Valuation (1st ed.). Somerset: Wiley.
Bierman, H., & Smidt, S. (2007). The capital budgeting decision (1st ed.). New York: Routledge.
Blackstone, William, and Edward Christian. Commentaries On The Laws Of England. [Place of publication not identified]: [Nabu Press], 2010. Print.
Capital Budgeting Valuation. (2013) (1st ed.). Hoboken, N.J.
Donovan, S. (2006). Budgeting (1st ed.). Minneapolis: Lerner Publications Co.
Hornstein, A., & Yeung, B. (2005). Essays on the corporate capital budgeting decisions of multinational enterprises (1st ed.).
Jacobs, Davina F. A Review Of Capital Budgeting Practices. Washington: International Monetary Fund, 2008. Print.
Kalyebara, B., & Islam, S. Corporate Governance, Capital Markets, and Capital Budgeting (1st ed.).
Nice, D. (2002). Public budgeting (1st ed.). Belmont, CA: Wadsworth/ Thomson Learning.
Rasmussen, N. (2003). Process improvement for effective budgeting and financial reporting (1st ed.). Hoboken, N.J.: Wiley.
Shah, A. (2007). Local budgeting (1st ed.). Washington, D.C.: World Bank.
Vogt, A. (2004). Capital budgeting and finance (1st ed.). Washington, D.C.: International City/County Management Association.
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