Management Decision Making With Capital Budgeting Techniques

Capital Budgeting Techniques

Decision making is the most vital part in the working of a company. A strong decision making procedure can construct a strong base for the management of the company. It is very important to execute a proper planned decagon making process; else a wrong decision may have negative effect on the image of the company. Decision making is a process of elimination, which requires complete examination of various situations and chooses the most appropriate path as per the situation. It is a goal oriented procedure. The business world is dynamic in nature and a new situation arises every now and then, in order to cope up with these complexities, it is necessary to have a strong decision making procedure. (Berman, Knight and Case, n.d.)

In order to have a strong decision making process, all the levels of the entity are required to work together. The main decision making is done by the top most management, and then it is implemented. In order to implement a decision in the best possible manner, it is important for the middle and lower levels of management to work together as a team. Therefore, it is important for all the levels of the management to work in sync. The leaders in an organisation play a very important role in this part, as it is there main objective to keep all the blocks united so that proper functioning can be carried out. In order to cope up with the increasing completion, all the levels of an organisation need to work together in a group. (Bruner, Eades and Schill, 2017)

Capital budgeting is one of the most used and popular tools of decision making. It is simple method which helps in Deion making with the help of simple data amiable with the company. Capital budgeting is the technique whereby all the incomes and expenses of a planned project are analysed and then the decision whether to accept or reject the project is taken. In the process of capital budgeting the cash inflows and outflows are determined and estimated, so that the potential result can be compared with the target. (TULSIAN, 2016) 

Given a choice an entity would want to all the projects which would earn profits. But due to limitation on availability of capital and resources, the entity needs to make the decision of acceptance of a project which would earn them the highest results in the limited pool of resources. (Clarke and Clarke, 1990)

There are various tools in capital budgeting which helps the process of decision making. These tools are easy to use an implement (Taylor, 20080029. Few of which include, discounted cash flow analysis, net present value, Internal Rate of Return, Pay-back period, etc. Let us now discuss these in details:

• Discounted Cash Flow Analysis:it is the tool whereby the estimated cash flows and inflows of a project are discounted using an appropriate rate of return. The discounted cash flows help the entity understand the return in terms of money whose value can be determined today. (Galbraith, Downey and Kates, 2002)
• Net Present Value:Net present value is the tool which helps the entity understands the profitability form the project. Net present value is the difference between the discounted cash inflows and cash outflows. When the result is positive the project said to be viable and is accepted, when negative the project is rejected (Shim and Siegel, 2008).  Let us understand this using some numerical, considering two projects project A and B with the given cash flows and rate of return being  percent, the net present value will result as:

Therefore, we would accept Project A since NPV of project A is more than that of project B.

• Discounted Pay Bank Period: only positive returns Is not the requirement of investors. The investors require that they recover the invested amount as soon as possible so that they can start earning profits. Discounted pay back is the technique which helps us analyze the time period in which the invested amount will be recovered.(Hassani, 2016)
• Internal Rate of Return: IRR is the tool which helps us understand the actual returns of the project.  In this technique the discounted cash inflows are equaled with cash ooutflows in order to determine the hidden rate of return from the project. If the IRR is more than the required rate of return then the project should be accepted, it not then it should be rejected. From the example provided above we calculate the IRR of both the projects.(Holland and Torregrosa, 2008)

Capital Budgeting technique is a very important technique. Let us put some light on few of its importance’s:

• Helps in Risk Evaluation: Capital expenditure involve long term investments which are subject to high financial risks. Therefore, it is important to evaluate the investment scoped first before investing in any new opportunity.
• Assist in choosing the best available opportunity: As already discussed due to limitation on capital and resources availability the entity is limited to choose the best option. The technique of capital budgeting helps to evaluate the results from all the available options so that the one with highest results can be recommend and accepted by the entity.(Khan and Jain, 2014)
• Lock-in period of investments: in some cases of investments the investors are required to lock in their investments for a certain period of time. In case if the project turns out not to be profitable the investor is still stuck with it due to the lock in period. In order to avoid such situations, the capital budgeting technique helps to evaluate the project beforehand.(Saltelli, Chan and Scott, 2008)
• Evaluation techniques: the capital budgeting technique does not only help in decision making, but it also helps the investors evaluate the various pros and cons of a particular project. It helps in better comparison and lets the investor choose the best form all the available options.(Saunders and Cornett, 2017)

Capital budgeting also helps in various other kinds of analysis. Few of which have been discussed below:

• Sensitivity analysis: this kind of analysis helps in determining how an independent value will affect the dependent values given a certain set of assumptions. The system of sensitivity analysis helps to measure the responsiveness of one factor based on the other (Palepu, Healy and Peek, 2016). For example, the effect of change of interest rates will have on the prices of the bonds issued; this is the most common exam of sensitivity analysis. There are various steps which are required to be followed while conducting a sensitivity analysis of a given situation or a project, we have discussed them as follows:
• Let us have a base case output, assuming it to be the net present value (N1) of a project based on the inputs I1.
• Now we will determine the value of new output based on change in the inputs. Let the new NPV be N2, based on certain % change in inputs I1.
• Now we would compare the percentage change in NPV with the % change in input. Suppose the NPV changes by6% with 1% change in the input factors.
• Sensitivity will now be calculated by dividing the % change in output by % change in input.

The result of this analysis will now be evaluated on how much the output changes with the change in input. (Phillips, 2014)

• Scenario Analysis:under this system of analysis the analyst are to determine the value of a given security or a portfolio, after a certain period of time. Under this method the biggest challenge for the analysts are to determine the different interest rate based on expected scenarios which may or may not happen. The analyst then determine the interest rates for all these different scenarios, based on which the price or value or a particular investment or portfolio is determined. Though this is a complex way of determining the values, there are certain tools which help simplify the procedure, like standard deviation. Standard deviation is the tool which helps to determine the deviation of the market returns. These deviations are then multiplies and the prices are then calculated based on the upward and downward deviations. This analysis is a part of what if analysis which covers the result in a separate scenarios. In the system of sensitivity analysis the sensitivity with respect to input factors are calculated, whereas in the scenario analysis the change with respect to output factors are calculated. (Reilly and Brown, 2012)
• Breakeven Analysis:breakeven point is the point whereby the income of the company matches with the expenses. It is the point where the company is neither profit not at loss. This breakeven analysis is conducted in order to calculate the minimum level of sales or revenue that is required to be generated in order to breakeven the expenses of the company. Any portion of revenue generated beyond the breakeven point is considered to be the profit for the company. In order to set a minimum level of target, so that all the expenses made can be recovered, the break even analysis is used. Once the breakeven target is achieved the company can focus on earning profits. (Fairhurst, 2015)
• Simulation Techniques: the simulation techniques help the investors understand the result of capital budgeting in depth. In this technique the analyst mainly tries to understand the behavior of the factors given there are changes in the set of assumptions and scenarios of that particular situation. The main drawback of simulation technique is that it fails to cope up with uncertainties. This is the reason that simulation techniques are not as popularly used as the other techniques mentioned above.

Conclusion

Though the capital budgeting techniques are very useful and easy to implement. There are a lot of drawbacks too. Since they are built to evaluate the long term investment proposals, they cannot be implemented in the short term investment proposals. Lack of capital and other resources make it difficult to plan a proper budget which can be implemented.

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.

Taylor, S. (2008). Modelling financial time series. New Jersey: World Scientific.

Tulsian, b. (2016). Tulsian’s Financial Management For Ca-Ipc (Group-i). [s.l.]: s Chand & Co Ltd.

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