Capital budgeting refers to the process of allocating cash expenditure to investment which has a longer life than the operating period which is normally one year (Shim, Siege & Shim, 2012). It involves allocation of financial resources among alternative opportunities of investment.it is crucial that managers understand capital budgeting process and techniques since they help the company plan its long term investments. When undertaking this process, it is important to understand the time value of money and other factors that are considered when measuring the success of an investment project. Amazon PLC is the company that is used as an illustration in this report. Capital budgeting impacts on various aspects of a company such as the competitive position of a firm, profits and management responsibilities. This report analyzes the stages of the capital marketing process. Each stage is described in depth and illustrations are made. In addition to this, the paper also discusses the significance of each process to the organization. The report also discusses the various formulas of capital investment. The advantages and disadvantages of each method are discussed in detail in this report.
Amazon is a multinational technology company that focusses on e-commerce, cloud computing, and artificial intelligence. Amazon is one of the biggest companies in the world based on its market capitalization(Calabrese, 2011). The company has in place a very concrete investment policy which helps it planning its long term investment. This has ensured that the company has remained competitive and has invested heavily in new technology which has caused a lot of disruption in the market. For Amazon to determine and decide on investment, there is a procedure that the management of the company follows. The following is the capital budget process used by Amazon.com Inc.
Step 1: Identify and evaluate potential opportunities. To budget for capital in a company, it is crucial to start by coming up with various potential investment opportunities. The opportunities can be identified through various means. One of how Amazon Inc identifies potential opportunities is by interacting with customers to identify gaps that presently exist in customer satisfaction (Baker & English, 2011). After doing this, the company tried coming up with a potential solution to the problem. Another method that the company uses in identifying potential opportunities is by engaging employees to innovate and to provide a conducive environment for innovation. The employees can then come up with a project that they can forward to the management for consideration. Investment opportunities are also suggested by the top management of the company upon which they are evaluated to determine their feasibility. After all potential projects have been identified, an evaluation process begins. This is where the financial and logistical aspects of the project are considered and compared to one another. This helps the company to identify the most feasible opportunity after which it decides on the time of implementing the project.
Step 2: Estimate the operating and implementing costs. After settling on the opportunity that the company will invest funds, it is important to carry out a thorough financial analysis of the project. During this stage, financial projections of the project are made in detail (Stout, Shaffer & Schwartz, 2017). All the costs that will be incurred at the initial stages of the project and also in the future are determined. For instance, before Amazon decided to invest in Plant Prefab which is an innovative startup which focuses on factory construction and smart technology it had to analyze the costs of the opportunity. The company then finds alternative means of reducing costs if it is possible.
Step 3: Estimate cash flow or benefits
After estimating the costs of the project, the next step involves estimating the cash flow of the business. All the streams of generating revenue from the new investment are determined, and the potential of each and everyone is projected. One way of estimating cash flow is reviewing historical data from similar projects. If there is no similar project, cash flow can be estimated by just estimating the uptake of the new product or service(de Motta & Ortega, 2013). If the investment does not generate cash flow directly, the company must access the non-financial benefits of the project.
Step 4: Assess risk
This step usually involves estimating the risk that is associated with the project. One of the major risk factors that are considered when doing capital budgeting is the number of funds that the company stands to lose if the company fails or does not perform as expected (Scho?nbohm & Zahn, 2012). Amazon invests a lot of funds in many of the investments its undertakes both within the company and also in other company. Therefore, the company must evaluate how much it stands to lose in case things do not go according to plan. The organization then has to evaluate how the loss could affect its operations and other aspects of the business. The other risk that the company considers is the risk of government interference through unfavorable legislation. Despite its strong growth, Amazon has faced many challenges in recent years regarding government efforts to strictly regulate the industry and to increase its taxes. The company, therefore, has to consider the risk of the project facing political and legal obstacles. After determining the degree of risk, the company then decide whether the risk is worth taking given the expected benefits of the project(Mukherjee, 2018). If the benefits outweigh the risks, then the management can proceed to the next step of capital budgeting.
The fifth step of the process is about coming up with an implementation plan that will guide the company to track every step of implementing the project. The implementation step is the most important step in this process. This is because it is the step that determines whether or not the expectations of the investment will be met. After the proposal has been accepted, all steps necessary in the project coming to fruition should be taken. The management of the company puts together a team that will be charged with the responsibility of overseeing the investment. Some of the roles of the team include providing timely updates on the progress of the project and ensuring that resources are used optimally (Namanda, 2017). All the physical and financial resources needed for the project should be availed to the implementing team. The team in charge of implementation assigns roles to different people within the organization. A timeline for implementation of the project is also mandatory since the investment must bear fruits within the set timelines.
There are various challenges involved in capital budgeting by various organizations. The challenges experienced in capital budgeting contribute to wrong decision making by the organization and hence resulting in huge losses by organizations. One of the common challenges that Amazon faces in its capital budgeting process is that of estimating cash flows. It is very difficult for the management to project accurately the expected cash flow from any given investment project. Overestimation and underestimation of revenue by the company means that a project that looked profitable will result in losses (Kalyebara & Islam, 2014). The bad investments can, therefore, result in huge losses by the company. This problem can be solved by carrying out thorough research on the future outlook of the industry to determine the right range of cash flow. The challenge can also be solved by using historical data of similar firms in the industry.
Another challenge faced in capital budgeting is that it is difficult to achieve the objectives of the project within the set timelines. As time moves on, it becomes increasingly difficult to estimate the performance of the investment since there are some disruptive activities that may happen on over time and hence making it difficult to budget capital accurately. Unforeseen competition, legal and regulatory changes as well as technological innovations are some of the factors that make it difficult for the company to budget capital (Tong, 2017). This problem can be solved by continuous innovation once the company begins implementing the project.
Another major problem faced when carrying out capital budgeting is that it is difficult to determine discount rates correctly. The capital budgeting methods used by the company considers the cost of capital. It is very difficult to accurately determine discount rates and even when its determined accurately; there is a very high chance interest rate will rise and hence increase the cost of capital(Srithongrung, 2017).
There are various methods that investors use to make decisions on investment projects. These methods vary in approach, and they are equally important in making a decision on which project will be more beneficial to the organization over some time. Each method has its advantages and disadvantages, and it is important to understand this before settling on the method to use. The following is a discussion of the methods used in making investment decisions in capital budgeting:
The payback period method is the most popular method of capital budgeting. For this method, investment decisions are made based on the length of time it will take for cash earning to return the initial amount of funds invested (Crum & Derkinderen, 2008). It is used both before and after tax. The method is very simple since it considers only cash flow and period and does not consider discount rates. Payback period is expressed by the form P=I/E
For example, if Amazon decides to invest $10,000 in a new machine which generates a cash flow of $ 2,000 yearly, the payback period for this project will be;
10,000/2000= 5 years.
Supposing that the company can invest the $10,000in another project with a cash flow of $4,000, it means that the payback period will be calculated as; 10,000/ 4000=2.5 years.
For this method, the project with the smallest payback period is chosen irrespective of the project life.
Advantages
lIts easy to compute and understand especially for small businesses
The disadvantage of this method is that it does not consider the life of the project and hence its difficult to choose between alternative projects that differ in cost, payback period and productive life(Clayman, Fridson & Troughton, 2012). A short payback period does not necessarily mean the project is more profitable.
Another disadvantage is that of uneven cash flows. Net cash flows vary from year to high. The project may generate expected cash flow in the first few years, and something may happen to result in a decline in cash flows and hence the expected payback period will increase.
Net Present Value(NPV) is a method that is used to determine the current value of all future cash flow generated by a given project. This includes initial capital investment. It is useful in determining which project will generate more profits in the future. The formula for NPV is
In this equation:
i = Required return or discount rate
t = Number of periods
If a longer-term project with multiple cash flows is being analyzed, the formula for the net present value of a project is:
In this equation:
Rt = net cash inflow-outflows during a single period t
i = discount rate of return that could be earned in alternative investments
t = number of periods
The required rate of return in this formula is used as the discount rate for cash flows in future to account for time value of money. This is because the value of money changes over time. NPV formula is used to compare projects based on their expected rates of return, investment and expected revenue. The project with the highest NPV is selected.
It is based on the idea of the time value of money and hence considers changes in the value of money using the discount rate. (Mukherjee, Al & Lane, January 01, 2016)
Stakeholder of the company can see how much the project is expected to contribute to their value because the method estimates the value the project will add to the company.
The other advantage of NPV is that the method considers the project life of the project and hence all the years of cash flow are considered, and hence the value of the project is calculated more accurately.
lIt is difficult to estimate future cash flows and hence reducing its accuracy
lThe NPV method is not suitable for comparing projects that have different investment amounts. A larger project that requires huge investment means that a higher NPV but that does not necessarily mean that the project is better than the rest.
lIt is difficult to use this method when comparing projects that have different life spans.
The internal rate of return
The internal rate of return method uses a discount rate that makes the net present value(NPV) of all cash flows from a particular project equal to zero. The IRR formula is almost the same as that of NPV.
Where:
Ct = net cash inflow during the period t
Co= total initial investment costs
r = discount rate, and
t = time periods
To calculate the internal rate of return using this formula, the NPV should be set at zero and determine the discount rate which is (r). The ® is the internal rate of return of the project. Generally, the higher the IRR, the more desirable is the project. Therefore, when comparing two or more project, the project that is found to have a higher IRR should be undertaken.
One of the advantages of this method is that it considers the time value of money. IRR is calculated at the interest rates at which the present value of future cash flows equals the amount of capital invested (Kiget, 2014). This, therefore, means that the future value of money is estimated and therefore making the method more accurate in projecting future cash flows.
Another advantage of the IRR method is that it is simple. It is easy to calculate using this method and hence its easy and suitable to compare two projects. The method can, therefore, be used by small businesses to evaluate their investment projects.
The third advantage of the IRR method is that the hurdle rate is not required. The hurdle rate is also referred to as the cost of capital. This means that the risk of selecting the wrong rate is reduced and hence improving the dependability of this method.
The method does not put into consideration the project size when comparing different projects. This is a major short coming for this method because it is done only considers cash flows without regarding the amount of capital outlay for the project. It, therefore, means that a project could need a lot of capital and generate cash flows that are slightly higher than a project requiring less capital(Adkins & Paxson, 2013). This, therefore, means that a wrong project can be chosen as a result of this.
Another shortcoming of this method is that it ignores future costs. The method only considers future cash flows that will be generated from the project while ignoring the future costs of the project. It means that a project could be generating a huge amount of cash, but the costs are also so higher to the extent that the profit generated is so little. The method may, therefore, result in an investor choosing a less profitable venture.
The method also ignores reinvestment rates. This means that the method does not take into consideration that cash generated from the project can be reinvested to generate more cash and hence may ignore some cash flow from the project.
Conclusion
This paper discusses the steps of the capital budget for Amazon Inc which is one of the leading technology companies globally. The capital budgeting process at Amazon begins with identification and evaluation of potential projects. Potential investment projects can be suggested by employees or could arise as a solution to the challenges the company is facing in the market. After an evaluation of the project, the cost of project implementation is determined to understand what is required to launch the project and sustain it into the future. The next step is then determining future cash flows of the project; this helps in determining the potential future profits of the project. The next step is accessing risks of the project to determine whether the benefits outweigh the risk. The final step of the process is the implementation of the project. The report also discusses the various methods of project evaluation as well as the advantages and disadvantages of each method.
References
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