Brigham and Ehrhardt have defined capital budgeting as a planning process that managers use to identify projects which add value to the firm (2008). This is one of the most important tasks carried out by financial managers and their staff. Capital expenditures often precede the firms/ organisations engagement into provision of new products and services or even before entry into new markets. The results of capital budgeting always have long lasting effects. Brigham and Ehrhardt (2008) explain that poor capital budgeting can have grave consequences on the organisation. Excess capital investments result in waste of the investors resources because it creates excess capacity which will certainly not be utilized. Low capital investment will result to reduced capacity due to insufficient resources such as equipment.
These effects can be compounded especially in cases where the firm loses competitive advantage which in turn may lead to loss of customers to rival firms. In addition recovery becomes a very hard tasks which may require significant tax reductions and product quality improvements which may be too expensive for the organisation. Capital budgeting involves determining which investments to pursue. This may include new plants machinery and projects. These are major investments and expenditures and require meticulous planning.
Financial management is concerned with making decisions regarding financing, dividends and investments within the organisations goal. One of the usual goals of corporate financing is to maximise the stakeholders’ wealth. Funds are invested in the long and short term. Capital budgeting is concerned with long term investments and may include acquisition of new technology, property, equipments, trademarks and patents among others(Brigham & Ehrhardt 2008). Capital investments can be differentiated from recurrent expenditures by two characteristics. First, capital investments are significantly large. Second, their benefits and cash flows spread over several years.
Business entities have an objective to be competitive in order to survive and grow. This however depends on the new innovative ideas and products as well as low operation cost. These new products and strategies must be supported by sound capital budgeting. This is primarily the role of financial managers. However, it is also important to acquire proposals from other employees. Firms and organisations that have capable and innovative employees with good management will often have many ideas with regarding to capital management. Some of these ideas are usually good while other may not be worthwhile. Determination of which ideas should be adopted and which ones should not is the responsibility of the manager. In addition to this, companies must screen and scrutinize projects prior to their implementation.
Capital budgeting investments are classified into three categories depending on the way they influence the decision making process (Dayananda et al 2002). These categories are. Independent projects, contingent projects and mutually exclusive projects.
An independent project is one which its acceptance or rejection does not affect the consideration of other projects or the likelihood that they will be selected (Jacofsen, 2002). On the other hand mutually exclusive projects refer to projects which cannot be carried out simultaneously (Jacofsen, 2002). If one is adopted then the other must be rejected. These projects involve either-or decisions because they cannot be pursued simultaneously. Mutually exclusive projects are evaluated separately and the one which has the highest Net Present value is adopted by the firm (Brigham & Daves, 2010). Contingent project is one which its acceptance is dependent on the decision to accept or reject one or more projects. In this case the cash flows of the two projects are interrelated.
Diagram showing the capital budgeting process. Retrieved from Dayananda et al (2002).
The capital budgeting process as shown in the diagram above is a multiple faced process with several sequential stages. These stages have been highly simplified in the above flowchart.
This is the plan which clearly shows the current position of the firm and its future intentions. “Strategic planning translates the firm’s corporate goals into specific policies and directions, set priorities, specify the structural, strategic and tactical areas of business development and guides in pursuit of solid objectives” (Dayananda et al, 2002, pg 7). The firm’s mission and vision are included in the strategic planning flame work.
Identification of investment opportunities
This step is very important and basically involves the identification of investment opportunities and development of project proposals. Dayananda et al (2002) explains that the proposals must fit to the firm’s corporate goals, its vision, mission and its strategic plan. Investments can be mandatory or discretional. Mandatory investments are compulsory and may be required by law. They include investments related to health and safety and are necessary for the firm’s operation. The discretionary invest opportunities are driven by growth opportunities, cost reduction opportunities and competition among others. Suggestions regarding which investments should be pursued can emanate from any department. Therefore avenues should be created to enable these suggestions and opinions to reach the top management.
Generally organisations receive many proposals on various possible investments. These proposals must undergo a rigorous analysis to determine if they are worth pursuing. Preliminary screening is done to isolate proposals that are not tenable because thorough evaluation will consume the organisations resources.
Financial appraisal of projects
The projects that pass the preliminary screening are subjected to financial appraisal to determine whether they have the potential to add value to the organisation.
“ the project analysis may predict the expected future cash flows of the project, analyse risks associated with those cash flows forecasts, examine the sensitivity of the results to possible changes in the predicted cash flows, subject the cash flows to simulation and prepare alternative estimates of the projects net present value” (Dayananda et al, 2002 pg7)
This is a quantitative project analysis which influences the project selection or investment decisions on the firm.
Qualitative factors in project evaluation
Once the quantitative aspect of the project has been evaluated, the project undergoes qualitative evaluation. Qualitative factors are those which have an influence on the project but cannot be quantified in monetary terms. Examples include;
- Environmental impact of the project
- Political attitude towards the project
- Consequences of consumption of raw materials
- Impact on the firm’s image if the project is socially questionable
- Possible legal difficulties with regard to patents and copyrights.
These issues can be dealt-with through engaging in discussions and consultations with the relevant groups or members of the community.
Project implementation and monitoring
After the project has undergone the above essential stages it is implemented by the management. The relevant departments of the firm are involved in its implementation for its success. Monitoring is necessary in order to detect and correct any deviations from the initial project goals.
Post implementation audit
After the project has been successfully implemented the firm may conduct an audit. This is important because it helps the firm determine the performance of the implemented projects. This step helps detect the previous wrong or rights which will enable the firm improve on future undertakings (Dayananda et al 2002).
Screening of projects is important and essential especially for larger and risky projects which may even require a more detailed analysis which should be approved at higher management levels (Brigham & Ehrhardt 2008). Thoroughness in such analysis is therefore important in order to avoid the various consequences that have been previously discussed. Companies which have many branches should have plant or branch managers approving low budget projects while the larger ones are approved by the board of directors (Brigham & Ehrhardt 2008). This should include proposals on new products and expansion into new markets.
The evaluation these project proposals can be done through the use of six methods to determine whether they should be adopted or not.
Net present value
This method is based upon the discounted cash flow (DCF) technique which involves two basic steps
- First, finding the present value of each cash flow which includes initial cash flow, discounted at the project’s cost of capital (Jacofsen, 2002).
- Summing the discounted cash flows. This sum is referred to as the projects net present value (Jacofsen, 2002).
Projects with a positive NPV can be adopted. However in case of mutually exclusive projects the manager should choose one with the highest NPV
Internal rate of return
This particular discount rate equates the projects receipts to the costs (Brigham & Daves, 2010). In simple terms the IRR is the projects expected rate of returns. This means that if the internal rate of returns exceeds the cost of funds used to finance the project then there will be a surplus which will accrue to the firm’s stakeholders (Brigham & Daves, 2010). This is the reason why the IRR is used to determine the feasibility of a project. This is because the IRR has a breakeven characteristic.
There are other methods which can be used to determine the feasibility of the project these are; modified internal rate of return, profitability index, playback and discounted playback among others. However the IRR and the NPV are most common.