How Capital Budgeting Techniques Are Related To Management Decision Making

Corporate Decision-Making and its Importance

The main basis on which an organization is established is based on the decisions made by its management. Hence, the process of decision-making has become an important part of the business because even one inaccurate command may prove to become hazardous for the firm resulting in huge losses in profit and status of the firm. Before coming to the conclusion of any case we should examine all the major factors which may affect the goal of the management. Therefore they should choose the most appropriate option in order to achieve their desired results. The decision-making process is having a main objective of accomplishing the ‘goals’ and it is also a continuous process because of the dynamic nature of the business environment which leads to change in plans because of new problems arising with a change in time (Berman, Knight and Case, n.d.).

There are different levels of the firm at which the corporate decision-making takes place like- bottom up or top down. The executer characterizes the corporate decision-making as the decision will be most appropriate only when it is taken effectively. Also, if there is no commitment from the lower or middle management, the large laid plans may become useless which may lead to failure of the management system. It is therefore important for the management to maintain a prospering and healthy relationship with intermediate and low-level management. Therefore, business decision-making is successful, as long as there will be ”glue” which will help the firm to be organized and also will lead to encouragement of the leaders who maintain stability in the business values, otherwise the entity will fall into their own trap, leading to the loss of competitiveness of the market (Bruner, Eades and Schill, 2017)..

Capital budgeting refers to the assessment of the various costs or investments with properties of huge nature .These costs or investments include the creation of new plants or long-term investments (Clarke and Clarke, 1990). It helps in determining lifelong cash inflows and outflows to assess whether favorable returns are incurred by the firm to accomplish the set goals or benchmark and thus it is also called “investment appraisal”.

For an enterprise, it helps to facilitate the use of all opportunities and projects, but because of the limited availability of capital at a particular point in time, management uses the technique of capital budgeting to determine the maximum return on all available assignments at a time (Fairhurst, 2015).

There are various methods of capital budgeting which includes net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period. This can be explained as follows:

NPV: There is a discrepancy between the present values of both the cash inflows and outflows which is used in capital budgeting to find the profitability of the project or long-term investment. A positive value of NVP indicates that the expected return exceeds the cost whereas a negative value indicates a loss in the business (Galbraith, Downey and Kates, 2002). For example- If there are two assignments A and B, and both have different structures of cash flow, also the required rate of return is 10.25% then the NPV of the cash flows will be shown as follows:

Capital Budgeting Techniques and its Types

IRR: It may be defined as the net interest rate at which all the cash flows will have an NVP equal to zero in a provided assignment or investment. The attractiveness of the investment may be calculated using this method. The rule says that if the internal rate of return of a new project exceeds the rate of return that the company requires, then the project is acceptable (Hassani, 2016). Also if it will be less than the company’s required rate of interest then the project is not acceptable. We are calculating the IRR from the same example we have taken for NPV:

DCF analysis: These are similar to the NPV analysis because it takes into account the initial cash outflows which are needed for funding a project, cash inflows and other future outflows in the form of maintenance and other expenses. Such costs are being discounted to the current date and the outcome number is known as NPV (Holland and Torregrosa, 2008).

Discounted payback period: This is a capital budgeting process that determines the time required to break down the cost of initial expenditure by analyzing and discounting future cash flows and monetary time values (Khan and Jain, 2014). By the rule, if the projects which are discounted with the payback period are less than the targeted period, then the project should be accepted and processed.

Importance of capital budgeting techniques is as follows:

• Evaluation of risks: Long-term investments are the capital expenses that contain noticeable and significant financial risks. Therefore, it is really important for a firm to access the capital budget for proper planning and functioning (Palepu, Healy and Peek, 2016).
• Finding the best course of action: It helps a firm to access all the possible course of action available in a particular project and then choose the best investment to attain the maximum possible returns on it. The main focus is of increasing shareholder wealth and helping the company to gain an advantage in the marketplace.
• Long run of the business: The capital budgeting helps to reduce costs and also helps to determine the company’s best and maximum profit (Phillips, 2014). Capital budgeting helps to make the business sustainable for long-term by helping it in accessing proper planning, analysis and avoid all inadequate investments.
• Irreversible Investments: Sometimes the firm need huge investments but the funds are limited. So, it is better to analyze all the provided information of the project before making any investment. Once a decision is made, the money which is being invested will have no option of reversing the payment.

There are various types of capital budgeting techniques such as:

• Sensitivity Analysis: In this, there are several different forms of variables which help to determine the outcome of a decision by doing a complete analysis. Assuming the certain conditions to be constant, the analyst determines the change in the dependent variables based on the different values ??of the independent variables. It is also called “What if analysis” (Reilly and Brown, 2012). This type of analysis may be used by anyone for any type of decision like the planning of a family vacation or making corporate-level decisions. The main concept of sensitivity analysis is to determine the changes in output based on the change in one input, keeping all other inputs constant.

For conducting sensitivity analysis, following steps should be kept in mind:

• The base case output may be defined by taking an example; like NPV at a particular base case input value (V1) for which the sensitivity needs to be measured after having all other inputs constant.
• Keeping all other inputs same, the value of output may be calculated at a new value of input (say V2)
• Then the calculation of %change in input and % change in output is carried out.
• At last, the sensitivity is determined by dividing the % change in output by % change in input.

After all the calculations, it may be concluded with the fact that higher the sensitivity figure will be, the more sensitive the output is to any change in respect to input and vice-versa.

• Scenario analysis: It is the process of calculation of the “expected value” of an asset in a specific time period assuming many differences in the value of factors such as interest rates, etc (Saltelli, Chan and Scott, 2008). It is also a technique where analysis is done by a certified analyst in order to calculate different reinvestment rates for the expected profit which are continuously invested in the business during a specific time period. This analysis helps to find changes in the estimate of the portfolios which are based on the happenings of the environment and thus follow the principle of “What if analysis”. The assessment may be used in determining the amount of risk present in the amount which is going to be invested which is relied on the various potential events, having high and low range probabilities. This analysis may help the investor to determine the level of risk that can be undertaken before investing the money anywhere.

There are several methods of approaching scenario analysis of which the most common is called standard deviation of daily or monthly security returns which is generally calculated to compute the expected value of the portfolio. This is the most appropriate method for an analyst, which may help him to analyze and determine the reasonable changes in the values of portfolios at a particular period of time (Saunders and Cornett, 2017).

It should be noted prominently that the two above-mentioned analysis are not the same. This may be better to understand using an example like if an equity analyst has a wish to conduct both sensitivity and scenario analysis to know the effect on the Earning per Share (EPS), he will calculate it by using the price to earnings (P/E) multiple.

The sensitivity analysis is dependent on the variables that affect the calculation and which can be described using the price of the variables and the EPS. The range of all possible outcomes is being recorded with the help of this analysis whereas in scenario analysis, the outcomes are determined on the basis of the situation or present environment of the firm. It should be checked by the analyst he need is updated about the scenes like market crash or any change in the rules and regulation of a company. Then he uses the various variables of the model in order to accommodate the present situation. If all of these factors are integrated together, the analyst understands the different results with a broad view, including all the results in all extreme cases, and uses different combinations of inputs of real life cases to determine the outcome.

• Break Even analysis: The Company’s break-even point can be defined as the point where the company is generating enough income so as to cover all costs and expenses which are incurred during a specific accounting period. According to the definition, there will be no profit or loss incurred as a result of which the company’s net income will be zero. It is necessary to note that the company is not using the payback period to determine the breakeven point as the payback period is related to pay back an initial investment in a particular period of time whereas the breakeven point is related to zero net income after calculating the total revenue and total costs to be equal. This analysis helps us to determine that how much sales is needed in order to return all the cost incurred in doing a business. The following points are needed to be considered:
• Accounting breakeven analysis: When the total revenue equals the total cost and the net income is zero, then accounting breakeven analysis takes place. This can be achieved when we calculate the ratio of variable cost to sales. Taking an example, if there is a given ratio of 0.65 then this states that with every rupee of sales of each unit, the contribution is 0.35. Thus, the contribution margin ratio comes to 0.35. Therefore the breakeven point can be calculated by the following equation:

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

If the depreciation is not added, then the same breakeven point is known as cash breakeven point. The value which touché the breakeven points show that there are zero returns on the sales. Thus, because of no profit, only the amount of money invested will be recovered.

• Financial breakeven analysis: NPV breakeven occurs when the initial investment is equal to the cash flow, that is, the net present value is zero. Therefore, in order to achieve the breakeven point,the analyst needs to access that amount of sales where the net present value is equal to zero.
• Simulation analysis: The term simulation means imitation of a situation or process. Monte Carlo simulation is an analysis of the pretending of the different processes of some real things or star of affairs which represent the key features of a system using random numbers. It usually means to add up the dimensions of the dynamic analysis to the capital budgeting as it contains the process of making up for several different situations which are respective to the assumptions made by the analyst about the risk factors present. It also looks after its interaction and several possibilities of changes in the variables. The following steps are to be followed to perform this analysis:
• Identification of the variables needs to be carried out for both cash outflows and inflows.
• All the formulas relating to the variables should be mentioned and then the determination of probability distribution for each variable should be carried out.
• Then, a computer program will be made in order to randomly select one value from the profitability distribution of every variable present and then determine the projects net present value using such values.
• The result of this calculation is not a small value but it is rather a profitability distribution of all the feasible expected returns.

It is a useful tool to improve the decision-making for investments by understanding the capital budgeting techniques till its depth. Howsoever, some uncertainties are not in the condition to be controlled. Hence, this type of analysis is not the perfect answer for all the problems as it may overlook the significant interrelationships present between the variables and thus may lead to wrong results with inappropriate conclusions (Shim and Siegel, 2008).

Capital budgeting techniques are important for the decision-making process, but there are certain limitations:

• Unknown and inappropriate investments make it hard for the firm to prepare a proper budget.
• All the decisions are needed to be analyzed carefully as they contain decisions pertaining to large amounts which are irreversible in nature.

References:

Berman, K., Knight, J. and Case, J. (n.d.). Financial intelligence for HR professionals.

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

Clarke, R. and Clarke, R. (1990). Strategic financial management. Homewood, Ill.: R.D. Irwin.

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

Galbraith, J., Downey, D. and Kates, A. (2002). Designing dynamic organizations. New York: AMACOM.

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

Holland, J. and Torregrosa, D. (2008). Capital budgeting. [Washington, D.C.]: Congress of the U.S., Congressional Budget Office.

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.

Reilly, F. and Brown, K. (2012). Investment analysis & portfolio management. Mason, OH: South-Western Cengage Learning.

Saltelli, A., Chan, K. and Scott, E. (2008). Sensitivity analysis. Chichester: John Wiley & Sons, Ltd.

Saunders, A. and Cornett, M. (2017). Financial institutions management. New York: McGraw-Hill Education.

Shim, J. and Siegel, J. (2008). Financial management. Hauppauge, N.Y.: Barron’s Educational Series.

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