Capital Budgeting Techniques And Analysis For Investment Decision-Making

Financial Decision-Making with Capital Budgeting

If sponsor acts on your recommendations that you are putting forward, what value will it add to the firm and should the sponsor take up the project or not?

Financial decisions are crucial for evaluating and determining most favorable terms for raising of capital. Sponsors while investing money into projects needs to understand the spending capital expenditure which can generate value for the firm (Broyles, 2007). Thus, the recommendations include step-by-step decision making such that cost of capital can be ascertained. The primary focus for managers includes to analyse future outlook that a particular project can generate, where capital will be invested, leading to increase in value for the firm. As in any project it becomes critical to compensate sponsors from capital employed and provide them with returns that they expect for covering their cost of capital. Capital budgeting is a procedure undertaken by most managers for assessing systematically sponsor’s investment and returning their cost of capital in a suitable manner (Stout, 2008). For understanding value that is generated from a particular project, managers need to estimate future cash flows and outcomes from the investment. Timings for each cash flow is also integral according to time value of money. Capital budgeting forms an integral activity that helps decide merits and demerits of an investment project, hence helps decide growth initiatives. Such assessment allows to ascertain investment rate of returns that will be generated from the project, hence evaluating whether a project will be unacceptable or acceptable. Through process of capital budgeting measurability and accountability of the firm is created (Magni, 2009). It identifies resources that a particular business needs to invest in and assessing their risks and returns of the sponsors. Without determining effectiveness of investment decisions, there remains minor chance to exist in the competitive marketplace. Sole idea behind a project investment or business is to earn profits, through capital budgeting long-term financial and economic profitability for a particular project can be best understood (Baker, 2010). Managers generally invests in projects that can benefit the future outlook for the firm for increasing overall value for the business. Managers key focus is to increase value and compensate investors or sponsors of projects through their capital employed with an expected rate of return. Cost of capital is the key to obtaining further future investments and sponsors for projects, hence goal of managers is to maximize returns over and above generating costs of capital. By adopting capital budgeting managers systematically assess each investment project of the sponsors. Capital budgeting enables managers to create an overall outlook and outcome for investments. At any point of time, a firm can undertake several projects at the same time. Hence, specific project inflows case by case investment analysis using techniques help generate future cash flow predictions.

Capital Budgeting Techniques

	Initial Cost	After-Tax, End of Year, Project Cash Flows, CFt
0 Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	1	2	3	4
Project S	-$10,000	$5,000	$4,000	$3,000	$1,000
Project L	-$10,000	$1,000	$3,000	$4,000	$6,760

The above two projects namely, Project S and Project L have been undertaken for analysis for estimating the future benefits or returns they are going to generate. These projects are estimated using five techniques namely, NPV, Payback period, ARR, PI and IRR for understanding their effectiveness and value that they will generate for the firm. In case sponsors take up the recommendations provided to them then the following will be the value addition done to the firm;

• Developing and formulating long-term strategic goals: Businesses needs to undertake several projects at the same time or one at a time. Through undertaking of such projects they make profits, which are done by development of long-term strategic goals(Baldenius, 2007). Long-term strategic business goals might be to undertake several projects to several projects and create competitiveness in the market. Such can only be implemented by means of capital budgeting techniques of Net Present Value, Payback period, Accounting Rate of Return, Profitability Index and Internal Rate of Return. Through capital budgeting techniques, managers are able to appraise value for every investment project thus creating a framework for the firm to establish and set its long-term future directions (Froot, 2007). Building and incorporating long term strategic goals are the key to success and sustenance of the business for the firm. Thus, in case a firm is not able to make a decision for its long-term it will lag behind amongst its competitors and will not be able to extend its core competency. Undertaking long-term strategic planning and goal orientation can be done, in cases current projects costs are ascertained. Financial decisions involving current projects are crucial for future planning and long-term success of the business, by understanding its cash-flows (Carmichael, 2008). Thus, capital budgeting recommendations allows a firm to generate value for its business by ascertaining long-term impacts for a particular project. 

 

• Seeking out for new investment projects: A firm’s capability to evaluate investment projects, allows it to look out for new projects. New projects are critical for any firm as it allow profitability for all key business functions and compete in their profits in the industry(De Reyck, 2008). Assessing a running projects cash flow will allow creation of funds for undertaking of new projects for future endeavors. Along with diagnosing set of current projects, it becomes critical that the firm undertakes future projects investment related decisions. A firm’s future investment decisions for all projects that it undertakes will help attain business growth. New projects can help value-add to the firm by generating cash flows for stabilizing in case current projects lag behind in their cash flows due to any unprecedented event (Cooper, 2011). Analysing capital budgeting decisions for current projects can help predict cash flows for the future that they can generate and planning for future investment projects that can yield future cash flows. Newer investment projects can also help regulate cash flows in cases any events happen, thus enabling stabilizing of firm’s businesses.    

• Estimating and forecasting future cash-flows: In case of any business firms, it becomes essential that it can foresee the future cash flows that are being generated from a particular project overtime(Zimmerman, 2011). Capital budgeting is a technique that allows executives to analyse potential project impact for understanding the impact on future cash flows that they are going to generate. Understanding nature of such estimated future cash flows will enable them to analyse whether such projects has to be accepted or rejected. A firm functions solely depending on its cash flows, that allows it to manage expenditures and plan ahead. In case a firm is unable to plan for its expenditure then it might end up making losses, that ultimately leads to closure for the business (Jain, 2013). Managers while assessing projects for their cash flows include cost of debt or interests that might reflect interests rate of debt capital. Prudent managers often also undertake and assume various scenarios depending upon economic situations that are prevailing. An unprecedented future cash-flow for the firm is required for its sustenance, enabling it to make profits throughout. Thus, recommendations using current projects planned will allow undertaking crucial decisions regarding firm’s expansion and other endeavors.       

• Facilitating transfer of information: A project evaluation procedure starts with its proposal of whether being accepted or rejected through numerous decisions being made at various authority levels(Stokes, 2008). Capital budgeting allows information transfer to appropriate decision makers within the scope of the firm, which are critical success factors for all potential projects. Risk assessment incorporation is another crucial aspect of capital budgeting that allows transfer of information. While capital budgeting decisions are undertaken and analysed risk, estimation is done for accounting for any unfavorable event that might occur. In cases of economic downturn, a firm’s business can be severely affected leading to lower number of projects. Such information will allow plan for expenditure and keep buffer for currently operating projects (Truong, 2008). Accommodating for such risks and events will be included in the capital budgeting procedure will be by way of reducing future cash flows. Capital budgeting technique also often incorporates higher discounted rates for such economic downturns. Getting detailed recommendations and other information regarding a particular project can help analyse whether the project will provide profits or losses in the future. Investment decisions within a firm are crucial for going ahead or stopping with a project. Such transfer of information allows to cover and analyse all potential risks that are facing a particular firm or a project. In cases of high risk projects, decision to accept a project is rejected outright whereas in cases of high return project that can generate positive future inflow is accepted (Miller, 2007). A project’s acceptance information is transferred throughout the firm and helps plan for other expenditures. Such transfer of information facilitates planning for all other departments within the firm that is not directly involved in the project. Thus, providing such information helps in value addition to the firm thus, yielding valuable inputs for strategic decision making. 

 

• Monitoring and Controlling Expenditures: Every firm needs to establish control over their expenditures for creation of necessary investment projects(Bierman Jr, 2012). A stable investment project that allows good returns can yield to be a profitable, but expenditures needs to be monitored and controlled for crucial benefits in capital budgeting processes. Every type and form of expenses needs to be monitored and controlled such that they do not cross limits and go beyond the firm’s capacity to facilitate such expenditures (Bennouna, 2010). Capital budgeting allows depicting future cash flows expected from a particular project thus, providing a target to the firm for expenditures. Once a firm has set targets regarding the cash flow it is going to generate from projects then it is able to undertake budgeting process for its entire business. Budgeting for entire business allows to set targets which can help monitor and administer expenses in all related and un-related departments (Gervais, 2011). In cases any form of expenditures overshoots then a firm sets controlling procedure to either do away, mitigate or reduce such expenditures to balance any negative effect.         

• Creating Valuable Decisions: Capital budgeting decision processes can help create decision rules which helps understanding acceptability or rejection for a project(Damodaran, 2007). The results from a well-planned and efficiently controlled project will allow ascertaining whether to proceed with a particular project or to close it down in the process for saving the firm from further wastage of money and time. Capital budgeting process allows two important decisions, one involving financial decision and other comprising of investment decision. When a sponsor agrees to a particular project proposal then he makes financial commitments to the projects that includes set of risks (Hall, 2010). Project can be delayed, cost overruns can occur and other regulatory restrictions can increase costs associated with projects and lead to time delays. Capital budgeting for projects includes analysing cash flow and future returns from a project which further enable creation of decisions for the entire firm. Activities of a firm are solely dependent on the returns that the investment of the firm generate. Such returns acts as the bloodline for functioning of the business and its activities (Frank, 2009). Major strategic decisions within the scope of the business is made from undertaking of such projects. Thus, it becomes indispensible that capital budgeting is made for projects such that decisions for the entire firm can be taken.  

Following from the above project analysis and benefits that can be rendered to the firm, it can be understood that the capital budgeting procedure is useful. Post undertaking of several techniques of capital budgeting, the following results have been obtained for the two above mentioned projects;

Method	NPV	Payback	ARR	PI	IRR
Project S	788.20	2.33	15%	1.07882	14.49%
Project L	1,004.03	3.30	23.8%	1.10040	13.55%

There are a multiple types of Capital Budgeting technique that are used in evaluation but managers adopt recommendations from one that can yield value to the business. The sole aim of this project evaluation technique is to understand which project can generate more value compared to the other. Net Present Value method that uses discounting techniques for analysing costs and benefits of cash flows is ideally suited for this proposal. NPV method estimates present value for all costs by discounting future values of cash flows, thus enabling determination of whether a project will be profitable in the future or yield losses. This procedure allows inclusion of all expenditures for better evaluation, which can in turn create value by analysing a projects contribution to the firm. Project L is considered better and more viable compared to Project S. Reasoning following from the above recommendation is that NPV for Project L is higher as considered to Project L, ARR, PI is also higher. However, payback period is higher for Project S as compared to Project L and IRR for Project S is higher. Though Project L will have longer duration for its payback but overall return generated from the project is substantially high compared to the other project. As key intention in this project recommendation is to increase value generated form the project, key objective is to focus on increase in NPV compared to IRR.  IRR is not considered for evaluating the projects as it calculates the project inflows to equate the cost of capital. Though such measure might be internally appealing to managers, the measure is not capable of generating cash flows or any benefits for the firm. It cannot reflect on much value creation for the firm hence has been ignored in the consideration for this project. Payback period in a way also is not an effective measure and calculates how fast returns from a particular project can be used in paying back its capital. Therefore creation of value for the firm is not at all included, thus ignored in the consideration. The payback period is also shorter than 4 years thus, it would be more prudent to invest in Project L for generating value for the firm. Businesses generally include capital budgeting techniques prior to project implementation and operation such that it can be aligned to corporate strategy. A corporate strategy to make long term profits or create sustenance for the business can be approved one all consideration for cash flows can be ascertained and such information approved by senior members of the management. Regulatory requirements needs to be considered and taken into approval for analysing long term impacts on the firm and the several projects that they undertake. 

References

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