Importance Of Capital Budgeting In Decision Making For Corporations

The importance of decision-making for organizational performance

The power of decision making lies in the hand of the management. Any decision whether related to a petty thing or a major thing has its own significance. The management of the company is held responsible for the wrong decisions as it has a direct impact on the performance of the company. Apart from the financial performance it may also harm the reputation of the company making it difficult to survive in the long run. There are huge number of alternatives available for a set of actions but is is important for the company to choose the best action in order to get the best result.

Decisions are to be taken at every level of the organisation i.e. at the top level and even at the bottom level. Decision making is considered a very complex task but it is equally important to bring into action the decision taken by the management. The decision taken by the management can be implemented only when there is a cordial relation between the employees of the company. In order to take decisions relating to the financial planning of the company, the capital budgeting is adopted by the management.

Capital budgeting is a wide term which helps in evaluating the expenditures and investment of the company that are huge in amount. The example that can be used to explain expenditure and investment are manufacturing a new plant and machinery or investing funds in some kind of long term instrument. This techniques takes into consideration the cash outflow at present along with the future cash inflows and to check whether the company would be able to earn the required rate of return. This can be also known as the investment appraisal method.

There is a huge importance of Capital budgeting. Few of them are-

• Risk evaluation- Making any type of investment whether long term or short term involve different types of risk, so before investing the funds the risk should be identified and evaluated which can be done through capital budgeting.
• Decision making- A company should not keep the funds idle, it should invest it in a proper place where it is safe and also helps in earning a good return. However, the funds available with the company are limited and hence it should  be invested intelligently after proper analysis. Capital budgeting helps to take decision whether it is prudent to invest at that place or not.
• Long existence- A company can exist in the longrun when the company is able to control cost and maximise its profits. A proper analysis and planning is required by the company in order to let the company exist in the long run.

The limitations of capital budgeting are-

• Markets are dynamic so there is a possibility that the decision of investment may sometimes be wrong which may affect the budget and the capital of the company.
• A decision that is taken may earn huge interest but there is also a chance of the investment defaulting.
• Decision through capital budgeting is taken for long term. However, if short term decisions are taken through capital budgeting it my have negative impacts on the company.

As we said that Capital budgeting is a wide term there are various methods that are involved in it. Few of them are Discounted cash flows analysis, Net present value, Internal rate of return and discounted payback period. However, the two most important are the net present values and IRR method which has been explained with examples below:

1. NPV- Net present value is calculated by deducting the amount of cash outflows from the amount of cash inflows. It is easier to understand through this formula that this method is used in capital budgeting to know if there will be profits or not and if there are profits then how much. A positive NPV is considered favourable whereas the negative cash flows is considered unfavourable.

1. IRR-  The internal rate of return is used to determine whether the investment in which the company is thinking of investing is attractive enough or not. The case when the net present values of all the cash flows is zero, then the interest rate is known as IRR. It is favourable when the IRR is greater to the required rate of return and it is considered unfavourable when the IRR is less when compared to the required rate of return.

1. The following example will help us to understand the concept of IRR and NPV in a better way. The cash flows of the two project are shown below:

These were the methods that are involved in the process of capital budgeting. There are also various techniques of capital budgeting such as Sensitivity Analysis, Scenario Analysis, Breakeven Analysis and Simulation Analysis.

The role of management in decision-making

There exist a huge set of variables; some are independent of others whereas some are dependent on each other. Sensitivity analysis helps to analyse the possible outcomes using these variables. Keeping some conditions constant, the changes in the dependent variable because of the independent variables is determined by the analyst. Sensitivity analysis is also popularly known as the “what if analysis”. It is important to do analysis of every petty things also, so now we know that corporate decisions are widely important and hence cannot be taken without doing proper analysis. This name itself suggests that any variation in the input will affect the output, other factors remaining constant. (Bruner, Eades and Schill, 2017)

The steps involved to carry out sensitivity analysis are:

1. There is always a base case unit which is used to determine the sensitivity of the given information keeping other things constant.
2. It is helpful in determining the output value when the other factors are kept constant apart from the new level of output.
3. There is a requirement of identification of percentage change in output and input.
4. The formula to calculate the sensitivity analysis is percentage change in output by percentage change in input.

From the above write up, it is clear to us that the higher the percentage change in output, the higher is the sensitivity figure. However, the decrease in the percentage of input keeping the output constant will also lead to increase of the sensitivity figure.

Scenario analysis helps to determine the “expected value” that an investment is going to give after a fixed period of time when there are certain factors that may change such as the interest rate. It is the work of an analyst to determine the expected values of various investments at different rates and suggest his client the best investment alternative. Market is dynamic in nature and therefore the return on the portfolio keeps on changing from time to time so this analysis helps to determine the extent of the changes. The investment may be volatile in nature I.e. there may be high risk or low risk. This analysis is helpful in determining the level of risk a person or a company is ready to undertake.

The level of risk is determined by calculating the standard deviation as it is considered the variable used to determine risk. However, the expected returns are calculated using the mean of the variables.  The certainty of the changes related to the portfolio may be calculated using this analysis. There may be confusion between the sensitivity analysis and the scenario analysis, it is important to know that they are different from each other. The example that can be used to understand the difference is – Suppose there is analyst who wants to analyse his client’s portfolio through both the techniques in order to know the effect it would have on the earning per share of the company by using the profit earning ratio. As we know that, the variables affect the valuation in the case of sensitivity analysis. It helps the analyst to know all the possible outcomes that can possibly occur. But in the case of scenario analysis the outcomes are dependent on various factors of the market. There may be any change in the laws of the country or poor performance of the economy that may have an adverse effect on the portfolio. Therefore, we can say that in scenario analysis the external factors come into play. Both the techniques together gives the view of all range of results in the presence of various factors when there are different units of input (Phillips, 2014).

It is the priority of every company to recover its cost first and then to earn profits. The situation when the company has no profit or loss is said to be the breakeven point for the company. The lower the breakeven point the better it is for the company as the company can earn profits earlier. In the financial terms, the net income of the company will be zero. There is sometimes confusion between the payback point and the breakeven point but these two are completely different concepts. Payback period is the duration which is required to pay back the initial investment whereas breakeven point is not considered for time but for volume of sales or units (Fairhurst, 2015).

The breakeven analysis can be subdivided into two categories:

1. Accounting breakeven analysis. –  The accounting equation for the breakeven point is,

Total Revenue= Total cost. It can be calculated in terms of volume of sales or in terms of units.  The formula for breakeven point is-

BEP = (Fixed Cost + Depreciation) /Contribution Margin Ratio.

If the depreciation is excluded from the breakeven point then it is known as cash breakeven point. We can observe that only the investment value is recovered from the project and there will be zero returns (Hassani, 2016). 

1. Financial breakeven analysis. – Financial breakeven analysis is the point when the NPV is Zero, in such a case the cash flow is equal to the initial investment.

Simulation analysis means imitating of some actions or pretending something. This analysis is carried out to find out the probability and interaction between the different variables of the group. This analysis is considered as a part of capital budgeting as it is a part that is important to take investment decisions (Khan and Jain, 2014). There are also various limitations of this analysis as ignoring the relationship between various variables can provide us with wrong information.

The steps involved in the simulation analysis are:

1. Identification of certain variables that directly or indirectly affect the cash flows.
2. Formula for th simulation analysis is stated along with the probability distribution of the variables (Palepu, Healy and Peek, 2016).
3. The distribution is considered as a sample and any one variable is selected randomly by the computer programme, the NPV of the project can be determined in this step.
4. It is observed that there is not a single value as an outcome but there is a probability distribution as a result that shows various possible expected returns.

References:

Bruner, R., Eades, K. and Schill, M. (2017). Case studies in finance. Dubuque, IA: McGraw-Hill Education.

Fairhurst, D. (2015). Using Excel for Business Analysis A Guide to Financial Modelling Fundamenta. John Wiley & Sons.

Hassani, B. (2016). Scenario analysis in risk management. Cham: Springer International Publishing.

Khan, M. and Jain, P. (2014). Financial management. New Delhi: McGraw Hill Education.

Palepu, K., Healy, P. and Peek, E. (2016). Business analysis and valuation. Andover, Hampshire, United Kingdom: Cengage Learning EMEA.

Phillips, J. (2014). Capm / pmp. New York: McGraw Hill.

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