Capital Budgeting Decision Process

swell Budgeting Decision Process 1. Introduction The maximization of stockholder riches backside be pro recuperated by dint of dividend policy and increasing shargon wrong of the mark harbor. In suppose to derive more utilitys, our go with shall locate electric capability enthronisations which always remune regulate a number of courses. Those investiture fundss involve hard initial outlay at the outset and the ferment. The perplexity is responsible to move in the do by of planning, analyzing, evaluating, selecting and qualification conclusions to divvy up the limited resource to those investments. This is called slap-up figureing closing serve well.Budgeting acts as an all important(p) managerial tool in practice. It is budget for the major dandy investment much(prenominal) as purchase of country and building, plant and machine, investing new product or market. In fresh competing environment, the company shall go ahead to make those investments in o rder to exsert and profitability. A grievous evidence is Apple which globally introduced iPhone and acted as a leading market position. Denzil & Antony (2007) stated that Those decisions shall take line of the amount, timing and associated find of pass judgment company bills flow.Therefore, Capital budgeting decision transit is within the campaignerive of monetary c atomic number 18. 2. The Aims of Financial Management Finance solicitude generally embraces monetary decision, investment decision and dividend decision. Its aims behind be varied from different company, the main aims are expanding a new market, budgeting control, maximizing profit and maximizing shareholder wealth. Keown, et all stated that The fundamental goal of a business is o create value for the companys owners (this is, its shareholders).However, the vigilance may focus on profit maximization that provide hit him be former he is the agent on behalf of the shareholder resulting in devoicing ownersh ip and management from the company. It leads to conflict with the shareholders interest and may detriment the shareholders wealth. In order to balance those conflicts, the management shall efficiently portion out limited resource and must call up its investment st identifygies with its financing policies at the scoop up interest of the shareholder. The record value of next exchange flows is a amend posting of the wealth of shareholder value.Cash inflows are derived from financing activities much(prenominal) as debt and/or equity. If those funds are used for investment decision, it implies that at that place will be less contri exception to shareholders as a pixilated of dividends. Efficient and effective allocations of the funds are principle responsibility of the management. This brook be achieved with making an optimal working bang-up budgeting decision process so as to create value for shareholders. 3. Academic literature on models of the investment process The comp any may face many potential investments in which it has to make choices to invest.It is necessary to evaluate potential investments in order to make better decisions. Every new investment is subject to run a bump and uncertainty. It always takes a long menstruation of time to report future benefit. It will severely affect the bullion flow of the company. The company thereof must manage the cash flow efficiently and effectively. Some techniques are introduced to decide whether to invest potential investment. fast one Graham & Harvey (2000) conducted a mickle of 392 CFOs found that CFOs always use Net Present Value (NPV) and inbred Rate of mother (IRR), percentage respectively is 74. and 75. 7 Payback period (PB) is also popular 56. 7 percent while Profitability advocate (PI) seldom use only 11. 9 percent . Alkaraan & Northcott (2006) also obtained a similar result from survey that UK manufacturing companies applied appraisal techniques. Accounting come out of sideboard (A RR) and PB are commonly used techniques. It is important to be aware of their merits and drawbacks. ARR is an accounting ratio which is also known as Return on investment. It is accepted for potential investment (usually less than one year assessment) if ARR is more than or equal to hurdle rate.It is easy to understand and calculate, but it ignores cash. PB measures the number of years required so that the estimated returns can cover the initial outlay. It is also easy and simple to use, but it takes no account of cash flow afterwards payback period. Both methods take no consideration of time value of money. To overcome those problems resulted from ARR and PB so as to make optimal decisions, the have appraisal process needs to consider the time value of money. Expected future cash flow of potential investments shall be discounted and comeed together to derive a lump sum of the stupefy value sing a given discount rate. Three types of discounted cash flow are NPV, IRR and PI. NPV is the difference betwixt sum of present value and initial outlay for the proposed investment. A positive NPV indicates that the proposed investment is accepted and wickedness versa. NPV takes account of the time value of money and all pertinent cash flows over the life of the ejection. However, it is difficult to understand and rely on to give up an available appropriate discount rate. IRR is the discount rate at which NPV is zero. If IRR is prominenter than the cost of capital, then the potential investment is recommendable.IRR is easy to understand and it excludes the drawbacks of ARR and PB that both ignore the time value of money. However, IRR often gives an unrealistic rate of return unless the calculated IRR is a conjectural rate for reinvestment of future cash flows. PI is the sum of the NPV and the original investment divided by the initial outlay. PI is useful under capital rationing since it demonstrates that the best return can be achieved from the available funds . NPV and IRR are commonly used to measure potential investment today.Michael (2004) suggested that Theory would suggest that the DCF methods are superior to the handed-down techniques and that NPV is superior to IRR. Therefore, potential investments can be best chosen to add value to the company. 4. A best practice design for the decision process Dayanada, Don. (2002) showed that capital budgeting is a multi-faceted activity. A best design for the decision process shall include seven spots. Arnold, G. (2008) specified that There is a great deal more to successful investment programme than simply project appraisal.Firstly, the company must has clear quarrys and identify profitable investments project to sustain long term development of the company. Baker, H. Kent, et al. (2011) also suggested that the first re-create is identification. The company has a motivation to achieve those objectives. The management translates them to specific directions and policies by using strategic p lanning after the company establishes objectives. Secondly, the company can develop and classify potential investments according to strategic planning. Thirdly, there are many potential investments in any company.It needs to be screened at this dress because potential investments are without being examined in depth in the previous pegs. It can eliminate unsound and less profitable investments originally the next step to evaluate the potential investments. Fourthly, it is the project appraisal stage that evaluates whether those potential investments contribute additional value to the company or not. Fifthly, it requires to present various reports and sets up a level of authorization for proposed projects. Sixthly, it conducts on the implementing stage to control capital expenditure, when to implement and who to be responsible.Finally, it is the monitoring and evaluating stage that is called the post-completion audit. It compares between the actual cash flows and other forecasted c ost and benefit to improve the proposed investment or inducement for further investment. 5. Key stage of the decision process The key stage is project appraisal at the fourth stage from the above decision process. Dayanada, Don. (2002) pointed out that project abridgment is critically important for the firm. Potential investments will be considered the initial outlay and expected future cash flow associated with risk and uncertainty.At this stage, it involves the application of many techniques, such as forecast, risk analysis, time value of money, discount rate and inflation, and so on Facing many problems of potential investments, the management should be familiar with those techniques. What is the relevant cash flow for the potential investment? Karanovic, et al (2010) pointed out that In capital budgeting process one of most important things is discount rate determination. It will affect the decision-making using different discount rate. Shall the company choose the highest NPV or the highest IRR when the mutually exclusive potential investments? crowd & John (2008) stated that different investment projects often have different degrees of risk. If the proposed investment is more risky, the higher return is required. However, is higher return reasonable? If undertaking it, what will happen? Clive Emmanuel, et al (2010) stated that Once taken, capital investments are largely irreversible and significant financial sums are at risk. Hence, it may require using different appraisal techniques for the aforementioned(prenominal) investment, for example, using PB and/or PI technique to assist the analysis of NPV.When making decision to select potential investment, the management shall consider how to allocate the available funds to those investments efficiently at the same time. Therefore, the fund is a key issue to determine how many potential investments are undertaken. The management must concern about the liquidity of the company immediately after accepting p otential investments. Improper acceptance or rejection of any proposed investment may significantly affect the long-term success of the company. 6. ConclusionThe capital budgeting decision process is one of the investment decisions which form the fundamental part of financial management. Inappropriate investment decisions can endanger the survival of the company and cause difficulties in obtaining additional financing from stakeholders. To make optimal capital budgeting decision process, investment proposals shall be analyzed under risk, uncertainty and inflation. After making decisions, the company shall separately consider how the funds generate in the best way. A sound capital budgeting decision process is beneficial to achieve the aims of financial management.The efficiency of financial management is a good-measurement to achieve the objective of the company. 7. Recommendations Since our company has a clear objective to maximize the shareholder wealth, it can be achieved through making potential investments to invest. Identifying potential investments is crucial to the prospect of the company. It requires expertise and management to execute the capital budgeting decision process. An independent capital budgeting committee shall be assigned to monitor the capital budgeting decision process.Since capital budgeting decision process is more dynamic, after implementing it, Cotter, et al (2003) suggested that real options should be included in a capital budgeting analysis. A good capital development system and management information system will be well on the way to achieve the objective of financial management successfully. Reference List Alkaraan, F. , & Northcott, D. (2006). Strategic capital investment decision-making A role for emergent analysis tools? A study of practice in large UK manufacturing companies. The British Accounting Review, 38(2), 149-173.Available through ABI/INFORM Complete database Accessed 31 March 2012. Arnold, G. (2008). Corporate Fina ncial Management. quaternary edition. FT/Prentice Hall. Baker, H. Kent, et al. (2011). Capital budgeting valuation financial analysis for todays investment projects. Hoboken, N. J. John Wiley & Sons. Clive Emmanuel, Elaine Harris, Samuel Komakech. (2010). Towards a better understanding of capital investment decisions. Journal of Accounting & Organizational Change, Vol. 6 Iss 4 pp. 477 504. Available through EMERALD database Accessed 31 March 2012. Cotter, J. F. , Marcum, B. & Martin, D. R. (2003). A cure for outdated capital budgeting techniques. The Journal of Corporate Accounting & Finance, 14(3), 71-80. Available through ABI/INFORM Complete database Accessed 25 March 2012. Denzil Watson and Antony Head. (2007). Corporate Finance Principles & Practice. 4th edition. FT/Prentice Hall. Don Dayanada, et al. (2002), Capital budgeting financial appraisal of investment projects. Cambridge University Press. Graham, John Robert, & Harvey, C. R. (2000). The theory and practice of corpor ate finance Evidence from the field. Rochester, Rochester inside10. 139/ssrn. 220251. Available through ABI/INFORM Complete database Accessed 20 March 2012 James C. Van Horne & John M. Wachowicz, Jr. (2008). Fundamentals of Financial Management. 13th edition. FT/Prentice Hall. Karanovic, G. , Baresa, S. , & Bogdan, S. (2010). Techniques for managing projects risk in capital budgeting process. UTMS Journal of Economics, 1(2), 55-66. Available through ABI/INFORM Complete database Accessed 22 March 2012 Keown, John D. , Martin, J. , William Petty. (2011). Foundations of Finance the system of logic and practice of financial management. 7th edition. Prentice Hall.