Discuss about the Management Decision linked to Capital Budgeting.
Capital budgeting is a decision making tool that managers make use of, for evaluation of particular projects (Stout, 2008). Businesses determine positives and negatives associated with a project or an investment decision, which forms a part of company’s growth prospects. Capital budgeting processes helps decide on cash flows from a particular project by understanding cash flows that are generated from the project. A company determines rate of return which are acceptable or unacceptable depending upon factors of a project. Capital budgeting processes creates measurability and accountability for businesses that needs to diversify its resources in particular projects. With proper understanding of risks and associated return it becomes easier to have ownership and responsibility in regards to a particular project (Baker, 2010). Effectiveness of an investment decision or of a project is understood in this manner or else there will be minor chances of business existence in competitive marketplace. As sole motive for businesses is to make profits for its shareholders, capital budgeting processes needs to be encompassed for understanding long-term financial as well as economic gains. In corporate decision making, management can make decisions pertaining to sensitivity analysis, break-even, scenario or simulation techniques. However, all pertinent management decisions are linked to capital budgeting techniques including net present value, internal rate of return, accounting rate of return, payback period and so on and so forth (Bekaert, 2009). All pertinent management decision are taken with the aid of capital budgeting processes. The scope of the following analysis establishes relationship of capital budgeting techniques and procedures with that of managerial decision processes, evaluating scopes and application for each.
Capital budgeting is integral for businesses as it enables creation of structured process for better managerial decision making. For long-term strategic goal development is generated by attracting new projects and creating business cash flow forecasts (Garrison, 2010). Each and every capital budgeting techniques involves undertaking assumptions for making future estimations regarding project performance. Results from calculations from capital budgeting decisions often emerge to be inaccurate which leads to unexpected outcomes. In cases of low profits, then company can break-even due to bad economic conditions.
Sensitivity analysis allows businesses to develop estimates with projections in cases they turn out to be unreliable. It encompasses changing assumptions for understanding impact on project finances, which allows business managers prepare for unexpected results (Jackson, 2010). In every investment projects, net present value (NPV) or accounting rate of return (ARR) or other methods are utilized for calculations with different rates of return for conducting sensitivity analysis, which in turn will allow making a decision. Through sensitive analysis, business managers can better generate results that can create expected results, such that they can analyse project investment in a better manner. In case a business investment can earn $500, $1500 and $2000 in initial three years of the project. In case the business makes initial investment of $3000, which can be generated within the first three years. In case the project performs better in the first two years compared to its expectations, then it can easily break-even within the first two years (Miller, 2007).
An example of sensitivity analysis encompasses, an investment decision for $100,000 is said to generate returns of $10,000, $30,000, $50,000, $45,000 and so on in the first four years of its commencement. Managers determine that there could be an increase of 5% in total cash flows in case cost of capital comes down by 10%, then financial model for the investment decision for sensitivity analysis will be to estimate what will happen to investment decisions in case cash flows increases by 10%, 50% or 100%. Sensitivity analysis reflects that higher cash flows are sensitive to lower costs of capital involved. In case of sensitivity analysis, different values of independent variable can generate impact on a dependent variable with sets of assumptions. It is applicable in cases where there is more than one variable as effects that changes interest rates in bond prices.
Scenario analysis is another integral concept in managerial decision making. It analyses expected value from proposed investment or business activity with statistical mean being the highest probability event expected for a situation. Multiple scenarios are combined with various probability with which they occur can enable better determination of value of an investment. Probability of calculating expected value with which it will occur allows managers determine productivity of an investment alternative (Gervais, 2011). Probability distribution of an investment helps analyse risk inherent to an investment, which in turn allows calculation of expected rate of return. Through this procedure risk tolerance of the company’s investment decision can help create better prospective for the investment or business venture. Scenario analysis can be applied in many ways using multi-factor analysis or random factor analysis. Multivariate model are also used in multiple instances for forecasting values. Assuming values of each variable, most probable mean value of potential distribution can be ascertained (Tayles, 2007). Mean has informational value but does not depict variation in outcomes. Risks analysis is crucial for determinant for any type of project, especially for future outcome predictions. Mean is assumed to be a mid-path between extreme positive and negative side for any investment alternative. Scenario analysis often computes multiple net present values for the project with multiple different scenarios. In capital budgeting processes, the first or initial capital budgeting estimate is deemed to be base-case scenario. From the base-case other cases are generated and determined or developed (Besley, 2007). Managers compute several NPVs based on best economic situations and also worst economic situation which entail better decision making for the company.
Break-even analysis is a point that determines a point where costs equals revenues generated from an investment project. With this calculation, managers estimates margin of safety for a particular investment project. When the amount of revenue exceeds amount of investments made then it is assumed that the investment has attained its break-even point (Zimmerman, 2011). Break-even analysis is however, a supply side analysis that incorporates costs of investments, it does not assesses ways in which cash outflows might determine costs of the capital. Therefore, at break-even point losses equals to gains, hence managers in a business needs to determine this point to understand profitability. Costs are important in understanding of break-even analysis as fixed costs, variable and semi-variable costs. In an investment project, fixed costs are those which does not change over time or increases or decreases (Jain, 2013). Fixed costs in a project are those which the company has to pay in case of independent business activities. Such costs are total of services or goods provided. An example includes, for a project delivery the company needs to lease instruments worth $200,000 which does not change with specific components within the project, hence needs to be spread over across all its units. In case the project costs of capital is spread across longer duration of time then fixed costs components will be spread as against in case costs of capital is concentrated in a particular period, which leads to higher fixed cost appropriated within the time period. Variable costs are however, dependent on specific outputs. In case project activities are strained then it leads to higher variable costs as those arising from rents, office supplies, insurances and so on (Bierman Jr, 2012). Semi-variable costs on the other hand are semi-fixed costs that is a mixture of fixed along with variable costs components. Labour costs can be termed as semi-variable in nature and there are other semi-variable costs as well that are associated with certain project output. Break-even analysis often involves adjusting costs of capital for assessing project benefits or outcomes. Company managers determine competition-driven cost calculation tactics that can render competitive advantage in the market. Competitive costing and calculation of rate of return for a particular project helps attain a profitable market share, by controlling excessive costs that might arise from particular projects (Baldenius, 2007). In break-even analysis, capital budgeting technique of payback period is assumed for managerial decision making. In case a project costs is $100,000 and cash flows from it in first years of its progress are $20,000, $70,000, $ 40,000 and $30,000, then it can be understood that payback period for the project is estimated to be at 2 years and 3 months. Thus, at 2 years and 3 months the project can be assumed to attain its break- even point. Thus, payback period and NPV from the project which are capital budgeting techniques are used for understanding managerial decision making in break-even analysis as well.
With most capital budgeting techniques being focused on decision making models as NPV, ARR, IRR, Payback Period and so on, which often goes on to including taxing implications as well. These models however do not include any random figures and are determined using single figures with them (Froot, 2007). Hence, it can easily be understood that cash flows with uncertainties are ignored in all respects, which leads to analysing a project from single aspect of risks expressed in terms of a single discounting rate. For capturing greater amounts of risks from a project, it is required that the project delivers over normal returns. A simulation based model have capabilities to imitate real life situations when adapting to capital budgeting techniques. Thus, managers encompass this technique along with application of capital budgeting decision making tools to arrive at consolidated real-life figures with probability distribution connected to every cash flow from an investment. In order to drive random model, simulation techniques are assumed with random numbers from 0 to 1, it can be easily accommodated into Excel tool using –RAND() within a particular cell. This project thus encompasses all risks endeavors in capital budgeting decision making within an economic situation. Probability of a calculation makes it more practical oriented approach for determination of likelihood of cash flows that a project is expected to generate. NPV which is a technique of capital budgeting thus is used for generating decision making capabilities in simulation as well.
As contradictory to other tools for decision making which involves singular aspects, capital budgeting decision making includes financial decisions as well as investment decisions. When shareholders of a business agree to investment in a particular decision, then they make financial commitment to it along with substantial risks (Chen, 2008). Risks from projects can be multifarious as delays, cost overruns, increase in costs, regulatory changes, taxation changes and so on. Further, an investment decision will have an impact on future decision and growth for a company. Hence, project evaluation from investment or financial decision-making can create tremendous limitation for the project (Truong, 2008). Hence, a series of steps needs to be taken for managerial level decision making which will create long-term strategic orientation for the Company.
Conclusion
Managerial decision making includes critical aspects that can generate returns for the business and in turn for its shareholders. Capital budgeting techniques includes various processes that can estimate returns from a particular investment project. Managerial decision techniques as sensitivity analysis, scenario analysis, break-even analysis, simulation techniques and so on uses capital budgeting techniques for their analysis. Integrating such techniques is critical for arriving at values for managerial decision making with various discounting rates or values. Thus, capital budgeting decision techniques forms a crucial aspect for managerial decision making for estimating future cash flows. It facilitates transfer of information for various investment projects, which are in turn required for acquiring new investment projects. It also facilitates monitoring and controlling of expenditures for long-term strategic decision making.
References
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Bekaert, G. &. 2009. International financial management. Upper Saddle River, New Jersey, NJ: Pearson Prentice Hall., 809.
Besley, S. &. 2007. Essentials of managerial finance. Cengage learning.
Bierman Jr, H. &. 2012. The capital budgeting decision: economic analysis of investment projects. Routledge.
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Jackson, J. 2010. Promoting energy efficiency investments with risk management decision tools. Energy Policy, 3865-3873.
Jain, P. K. 2013. Capital Budgeting Decisions. In Financial Management Practices . Springer India., 37-76.
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Truong, G. P. 2008. Cost-of-capital estimation and capital-budgeting practice in Australia. Australian journal of management, 95-121.
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