Capital Budgeting
Capital Budgeting A key challenge in private, public corporations and even governments is the issue of budgeting and more so on appropriation between recurrent and development expenditure in government and short term and long term investment in corporations. In a Government setup, monies have to be appropriately allocated between development expenditures of the country and equally important are the recurrent expenditures. Whereas infrastructural investments such as roads, energy and railways are imperative for an economically growing and stable economy, civil servants and other government employees have to be remunerated as well because they have a role to play. This therefore calls for the government to decide on where to place more money and why. The enigma of allocating limited funds for all crucial expenses and use is a challenge to limited corporations as well. This paper will be focusing on capital budgeting in corporations, how projects are appraised and why some project appraisal methods are better than others. In order to decide which project to undertake or where to invest and when, companies do an evaluation of project, and a decision is made based on cost benefit analysis of the same among other considerations. Large companies use somewhat complicated project appraisal procedures by discounting cash flows where money is not taken in its current value, but rather discounted to arrive at the right future values of projects cash inflows (Sullivan & Steven, 2010). These computations may be difficult which explains why a majority of small and medium enterprises depend on simpler ways of determining a good project to undertake and which is not. Important to note is the percentage of economic importance of small and medium sized companies in any economy (Davina, 2008). In the U.S. for example small and medium size companies produce close to 50% of private GDP (Gross Domestic Product) and offers close to 60% of all jobs in the private labor force. In order to continue creating enough revenue to pay its workforce and expand companies requires substantive capital investment, which equally requires a well thought and articulated investment plan. This paperwill focus on capital budgeting in businesses and how various methods of project appraisal can affect the decision made by managers or accounting practitioners. This textual research paper aims at providing an overview of capital budgeting and how different methods of project appraisal can be used in capital budgeting including flaws in some of the methods.Limited education of some of the owners of small firms and not fully qualified staff are partly to blame for use of unsophisticated evaluation tools. However, it is important for such small and medium enterprises to understand that there is every reason why discounted cash flow analysis are imperative when evaluating projects. This paper will focus on why it is important to classify projects as short term and long term and implication thereof in budgeting. Long term project are those which are more capital intensive and futuristic in nature, in the sense that their benefits will be realized in the future. Short term projects on the other hand are those that require relatively low capital outlay and benefits are to be realized in a shorter period usually less than five years. Limited resources in company’s can be blamed sometimes asfor abandonment of economically viable projects over others (Sullivan & Steven, 2010). It is usually a hard decision to make, but one that has to be made nonetheless. This paper aims at providing an overview of capital budgeting in corporations and why it is necessary to appraise projects using discounted cash flows. Top business managers have a duty to manage and run companies to pre-agreed business status. Stakeholders invest their monies in corporations so that they get more money through reaping maximum benefits. This leaves the management with an uphill task of deciding how best and prudently will stakeholder’s money be invested. Two very important and related decisions have to be made and that is disclosing the investment that the company will undertake and how will the same information be communicated to the people with interests in the company. Investment decisions aimed at growing investor’s money are made through capital budgeting. In their quest to decide which investment is better than the other, various considerations becomes a concern to the managers. This includes the expected rate of return on investment to investors, risk profile of the project, time it will take for investors to recoup their investment and so on (Patricia, & Glenn, 2015). One of the crucial elements of business that capital budgeting focuses on is the expected risk and return. This is done through timing the cash flows that the project is expecting to return in a given period of time and further processing that information to produce a qualitative measure.For simple minded business people, such a decision is easy to make because they look at the project’s profitability and once that is determined, profitable projects areundertaken and non-profitable projects are dropped. The art of deciding how to appraise a project is very subjective and is usually left to the discretion of the practitioner or management. Some of the commonly used methods ofproject appraisal in capital budgeting includes; Net Book Value (NBV), Pay Back Period (PBP) and Internal Rate of Return (IRR) which are some of. At this point, reliable and relevant accounting information should be availed to facilitate processing of that information required for decision making. This accounting information is a crucial link between management and stakeholders mostly external who are also providers of capital. A relative common question among many investors is whether to invest or disinvest in a company. The same questions will ring in management’s mind as to whether to invest in project A or B. The answer to these question can be found in project analysis in capital budgeting.
The payback period
This may be used to mean the time that an investor will take to fully recover or recoup their investment in a project. This method basically tells an investor time lapse that they need to be aware of before the investment or project begin generating money for them. This method of capital budgeting and project appraisal precisely evaluates returns per year of the investment; and using that information to predict how long (period) it will take to pay back what was initially invested. This is a liquidity conscious method of capital budgeting because the manager or practitioner is determined to minimize liquidity risk to a bare minimum by recovering investment monies soonest possible (Fredrick, 2012). Under this method of capital budgeting, acceptance or rejection of a project is based on time it takes to recover or recoup initial investment. Whereas in many cases of payback period determination is subjective, assessments are made based on past experiences and risk levels. Payback period method of project appraisal can be very effective in short term investment projects (Davina, 2008). Short term investment projects are those projects that take shorter period of time to mature. Short term investment projects are characterized by early maturity and relatively low initial capital outlay. A short term investor waits for a short term period before recovering investment monies. This therefore makes this capital budgeting method most appropriate for such investors or investments considering that many managers appear to favor a payback of between 2 to 4 years. This method ceases to make any useful sense after payback period has been attained. After a payback period is determined, any project that is long term in nature will continue accruing benefits way after the payback period has elapsed and this may prompt wrong investment decision. It is therefore imperative to use this method in determining liquidity of a project instead of determining how profitable the project is. The formula for this method depends on whether cash flows are even or not. When cash flows are even, Payback period can be determined by dividing initial investment and cash flow per period. Payback period = Initial investment/Cash inflows per period (Fredrick, 2012). For uneven cash flows, Payback period = A+B/C where; A is the last period with a negative cumulative cash flow, B is the absolute value of cumulative cash flow at the end of the period A and C is the total cash flow during the period after A ( Kent & Philip, 2011). The decision rule is that projects with payback period less than target payback period is accepted. Example: When company XYZ is planning to undertake a project Ultra that requires initial investment of $ 60,000,000 which is expected to generate $15,000,000 in year 1,$18,000,000 in year 2, and $16,000,000 year 3, $19,000,000 year 4 and $22,000,000 year five, the payback of the project Ultra can be determined as follows; Year Cash flow cash flows (Cumulative) 0 -60,000,000 -60,000,000 1 15,000,000 -45,000,000 2 18,000,000 -27,000,000 3 16,000,000 -11,000,000 4 19,000,000 8,000,000 5 22,000,000 30,000,000 Payback period is 3+($11,000,000/$19,000,000) =3+0.5789. That is to say payback period is close to 3.58 years. The good thing about payback period is its simplicity to calculate and also liquidity focus aspect in ranking projects which helps companies having liquidity problems.
Net Present Value (NPV)
This can be explained to be the difference between cash inflows as expressed in the current value and cash out flows expressed in the current values. This method of capital budgeting is most appropriate when evaluating profitability of projects. T NPV=∑ {Ct/ (1+r) ^t} -C0 where Ct is net cash inflows during time t t-1 C0 is the total initial investment or capital outlay r is the discount rate and t is number of time periods. In determining a projects’ NPV, cash flows incurring in different time periods is discounted to represent the value at that time by multiplying it with a discount rate representing a minimum rate of return expected for a project to be profitable. Acceptance levels are any project whose NPV has been determined to be positive or any that has a zero NPV can be accepted. Benefits of using NPV in capital budgeting includes;
- It is seen as superior to other project evaluation methods,
- It takes into consideration time value of money because the value of a dollar today may not be tomorrow,
- This method makes uses of the entre project period and cash flows,
- It is easier to apply than some methods such as IRR.
Some drawbacks of this method include; unlike other methods like the IRR, this method expects the users to know the true cost of capital which may not be easy.The method is not very accurate in comparing projects with unequal economic life or ones which are unequal in size.
Internal Rate of Return (IRR)
With all its flaws, IRR is one of the methods that can be used to appraise projects in capital budgeting. IRR is a discount rate that equates present value of future cash flows to initial capital outlay meaning that investments positive cash flows and negative cash flows should amount to zero. Critics argue that this method has a weakness in that it allows a lot of assumptions that consequently lead to bad project decisions. Under this method, critics say bad projects look better and good ones looks even better (John and Justin, 2004). An investor will invest in a company that awards the highest rate of return in their investment and so will business managers do when it comes to projects. When focus is the returns on investment, IRR seems as the appropriate appraisal method to use. The method is not entirely a poor project appraisal method, but some adjustments can be made so that dangerous assumptions such as that interim cash flow will be reinvested at the same high rates of return, are avoided. If wrongly interpreted, IRR can be taken to mean the same as the annual equivalent return on a given investment (John and Justin, 2004). The correct interpretation is that a true indication of a projects’ annual return on investment can be determined using IRR when the project generates no interim cash flows, alternatively, the interim cash flows can be reinvested at the same actual IRR. Under IRR, an investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital (John and Justin, 2004). In a situation where a company has shareholders, minimum acceptable rate of capital can be taken to mean cost of an investment which can be determined through adjusting cost of capital of other similar investments (Shveta, Jain, & Surendra, 2012). For example, while appraising investment projects, a corporation can evaluate a new plant verses extension of an existing one on the basis of IRR of each. In such a comparison, project taken must surpass the other in returns thus having a higher IRR. It is calculated as: NPV =Sum {Period Cash Flows / (1+R)^T }-Initial capital outlay where R is interest rate as dictated by market forces and T is the number of periods which can be in years or tailored otherwise. Using the stated NPV formula, IRR can be calculated by solving for R by equating NPV to Zero.
Conclusion
It is imperative for businesses managers to invest prudently to safeguards stakeholders’ interests. This calls for investment appraisal methods of capital budgeting which is widely used now in investment evaluation. Managers have the discretion of using whatever method they are comfortable with, however, as discussed in this paper, different appraisal methods are better for different scenarios. Some managers will avoid some methods because of their complexity, but they may end up using a simple method that advocates for a bad investment decision given the circumstances. There exists a cycle between a manager, business performance and providers of capital, that is that stakeholders. This is all because the person at the helm of a business should be able to generate revenues for stakeholders. His/her performance will majorly be on the basis of turn over especially in todays’ competitive world. Review of employment contracts is based on growth and profitability which comes about after good investment decision has been made. Managers and other people in decision making organs needs to understand each method of capital budgeting so that they can invest prudently as this will not only benefit the company but also their employment contract may depend on it.
