You Should Remember
Capital budgeting is the practice of identifying and selecting investments in long-lived assets, or assets projected to generate paybacks over more than one year.
Capital Budgeting Decisions | Criteria | Substitute Directions | Implications
Capital budgeting is the practice of identifying and selecting investments in long-lived assets, or assets projected to generate paybacks over more than one year.
Since it is a mandatory for a firm to continually evaluate possible investments, capital budgeting is a continuous process.
Nevertheless, in prior to consider thinking about capital budgeting, it is must for an organisation to determine its corporate Strategy as a threshold approach. The corporate strategy determines an organisation’s broad set of objectives for future investment.
For example, the Walt Disney Company’s objective is to be “one of the world’s leading producers and providers of entertainment and information through the ongoing development of its powerful brand and character franchises.”
An organisation can attain corporate strategy by making investments in long-lived assets that will maximise stakeholders’ capital.
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Criteria for Capital Budgeting Decisions
During a project selection, it is very much mandatory to take shareholders’ interests into consideration. Possibly, there is an extensive range of criteria for choosing projects.
A convinced number of shareholders may want the organisation to select projects that will show speedy flows in cash inflow, and others may want to give importance to long-term performance.
Considering the possibilities from all directions, it would to a certain extent be difficult to gratify the diverse interests of all the shareholders.
However, there is a solution for it.
The NPV Is The Best Method
The organisation’s predominant goal is to maximize the current value of shareholder. This specific goal indicates that projects ought to be undertaken that end result in an optimistic Net Present Value, that is, the present value of the projected cash inflow less the present value of the required capital expenditures.
Using net present value (NPV) as a measure, capital budgeting comprises of choosing those projects that surge the value of the organisation for the reason that they have a positive NPV.
The timing and growth rate of the incoming cash flow is significant merely to the point of its effect on NPV.
Using NPV as the principle by which to select projects assumes resourceful capital markets so that the organisation has access to whatever capital is required to chase the positive NPV projects.
In circumstances where this is not the case, there may be capital rationing and the capital budgeting process turns out to be more difficult.
Overall, NPV is the finest method, principally for the reason that it addresses directly the central goal of financial management- maximising shareholder wealth.
Substitute Directions for Capital Budgeting
Despite the fact that net present value is the rule that at all times maximizes shareholder value, some organisations use other criteria for their capital budgeting decisions, such as:
- Internal Rate of Return (IRR) or Yield Method
- Modified Internal Rate of Return (MIRR)
- Profitability Index (PI) or Cost/Benefit Ratio)
- Payback Period
- Return on Book Value
In some circumstances, the investment decisions resulting from the IRR and Profitability Index methods agree with those of NPV.
Judgements made using the “Payback Period and Return on Book Value” methods frequently are suboptimal from the perspective of maximizing shareholder value.
Considering the effectiveness of all the methods, NPV is considered to be the best method mainly for the reason that it addresses directly the central goal of financial management and helps in maximising shareholder value.
Nevertheless, all the methods provide valuable information, and all are used in practice at least to some degree.
Implications of Capital Budgeting
In the process of financial decision-making, capital budgeting judgment has crucial impact as they have a vital influence on the profitability side of the organisation.
Furthermore, capital budgeting is substantial due to following factors:
- Capital Budgeting has long-term implications: The most substantial motive for capital budgeting judgments is that they have long-term implications for an organisation. Typically, the impacts of a capital budgeting decision extend into the future and have to be put up with for a lengthier period than the concerns of current working costs.
- Capital Budgeting involves a great quantity of funds: The capital investment decisions are required to be focused, sharp and accurate as they involve large amounts of funds. An erroneous or improper decision would end result in losses which may eventually prevent the organisation earning revenues.
- Capital Budgeting is the most critical and challenging decision: The capital investment decision is the most critical and challenging in the sense that such a judgment will have a in-depth impact on an organisation’s profitability in future.
- Capital Budgeting is not reversible: Once the decision making process pertaining to capital investment is done, it is not easily rescindable, for the reason that the second-hand capital assets may have neither any market nor any probability of exchange into other usable assets. At that point the merely solution is to dispose the same sustaining a hefty loss to the organisation.
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