Capitalbudgeting is an essential tool used by organizations or businesses tomake informed decisions on marketing and investments. It entails theprocess by which companies undertake the evaluation and ranking ofinvestments with larger capital requirements or those with largepotential expenditures (Dayanada,2002). Capital budgeting helps the company access whether its longterm investments like replacement machinery, new products, newplants, research development projects and new machinery areworthwhile to invest using the organization’s capital structure.
Thecompany decision on which investment to undertake is based on thepossible returns a particular investment will make. Through capitalbudgeting process the firm is able to access investments that areunprofitable or have lower returns in the long run and in effect arenot worthwhile to invest in at that moment. This offers a companyprudent outlook of the best investments projects and opportunities topursue that are profitable (Dayanada, 2002).
Toarrive at a particular decision, the company calculates the futureaccounting profit, the cash flow and the present value of the cashflows for a given duration of each investment project (Dayanada,2002). This is after putting into consideration the value of moneyover time and the duration a particular project will take to repay itstarting cash investment.
Capitalbudgeting involves several techniques utilized by managers fordecision making, it includes discounted payback period, paybackperiod, net present value, internal rate of return, accounting rateof return and profitability index (Dayanada, 2002). All thistechniques used cash inflows and outflows of a project to determineits suitability, but they differ in their approach.
Paybackperiod refers to the duration under which the initial cash inflow isrepaid by the given project. Shorter payback duration is oftenpreferred in comparison to extended payback periods. However, thedownside of this method is that it cannot account for risk, timevalue of money and financing. Net present value (NPV) gives anapproximation of project potential value by use of discounted cashflow (Dayanada, 2002). It is calculated by subtracting the totaldiscounted cash inflows from the initial cash inflow. The discountrate significantly affects the NPV, and corporates should carefullychoose appropriate rate in order to make sound decisions.
Internalrate of return (IRR) refers to the discount rate that provides a netcurrent value of Zero. The same outcome like that of NPV technique isarrived hen dealing with the non-mutually exclusive projects under afree environment. But the limitation of this method is that it isoften misunderstood to reflect the real yearly profitability of agiven investment. Profitability index (PI) gives the comparisonbetween the present value of future cash flows of a project and theinitial investment required for the project in ratio form (Dayanada,2002). It is an essential tool when a firm is ranking its projects.Therefore, these capital budgeting techniques determines howcompanies would maximize future profits from the small number of bigprojects it can manage at a particular time.
Asthe investors choose the specific investments to undertake, usuallythis marks the beginning of the investment process. Once theseinvestments are operational the investors need to monitor and managetheir performance. This is an essential practice which guides theinvestors to measure their portfolio and determines whether it isprogressing according to the set goals and objectives(Yeat al. 2009). When the portfolio has a positive progress, itindicates that the investment value is worthwhile. This means most ofthe investments are performing well but there may be one or twoinvestments underperforming.
Inthe event the overall performance of the investments are showingminimal gains or experiencing severe loses, the investors have tofind out the factors causing the decline and in effect make the rightmove. In order to avoid a decrease in value of the investmentsinvestors need to be constantly alert to the prevailing opportunitiesbecause investment markets fluctuate all the time (Ye at al. 2009).As such, the best strategy to adopt is to ration capital intodifferent investments in the economy as per capital budgeting. Forsafer security, the investors may also explore internationalinvestments.
Oncea given investment is underperforming the investor can sell it tofund other new investments that have better returns while retainingthe better performing investments. The measurement of the investmentsvalue for each investment should be done by comparing them withappropriate benchmark from other growth investments projects.
Partof diversifying their portfolios, investors may choose to invest partof their portfolio in foreign securities. This involves investorsmoving out of their home countries to explore new investment venturesoverseas. Before such a decision is made the investors carry out acomprehensive analysis of foreign securities such as exchange tradedfunds, mutual funds, bond offering and stock (Schutterat al., 2013). This offers investors with adequate information thathelps them determine the level of risks in a particular foreigncountry’s investment environment.
Foreigncountries’ risks include political, business and economic risks,which are often unique for each country. These are the major factorsthat may contribute to poor investments returns.
Economicrisk implies the ability of a country to settle its debts. Investorsare more interested in countries with stronger economy and stablefinances, because their investments will have higher potential toperform compared with less stable countries (Schutter at al., 2013).
Politicalrisks entails the political decisions made by specific countries,this decisions may contribute significantly to poor performance ofinvestments. As such it determines whether a country is hospitable toinvestors or not. Political risk is a major factor influencingforeign investment in that a country with lower economic risks butwith unfriendly political environment is still not favorable forinvestments (Schutter at al., 2013).
Investorslooking to undertake long-term investments projects, usuallyencounter a challenge of how to value these investments. This isbecause there are many risks or uncertainties to consider. Usingcapital budgeting, an investor can compare the returns of eachinvestment project (Ong,2006). In this method the value of the projects are obtained throughprojected financial calculation of cash flows.
Theexpected cash flow is achieved by discounting the required returnrate for a given project. Investors thus can make comparison ofinvestments performance under varied risk situations. To achievedifferent risk adjustment techniques, a number of modifications tocapital budgeting formula are done, and then an investor wouldcompare the performance of investments under varied risk situations(Ong, 2006).
Thefirst technique involves an increase of the expected rate of returndiscount to a given investment’s cash flows (Ong, 2006). Themodification will result to a reduction in the future value of cashflows showing there is an increased risk associated with the project.The second technique involves a reduction of future cash flows by aproportionate loss in percentage. That is, the modification is donewhen the investment returns is expected to experience risk ofunsettle payment, for instance the expected cash flows may bemultiply by 90 percent if it is expected 10 percent will not be paid.
Thethird technique can be calculated by making a delay of all the futurecash flows for a year. In effect this modification will decrease thevalue of the project by attaching a higher discounting. And the lasttechnique involves modifying the expected cash flow from theinvestment estimated net present value by subtracting the risk ofrequired higher start-up capital (Ong, 2006).
Anygiven project offers a particular financial risk. It follows that theproject’s funds should be managed well in order to ensure theexpected benefits are achieved. The management ought to be aware ofstrategies to adopt to ensure the funds are sufficient and willdeliver the set objectives (Saita,2007). Projects should be analyzed before investing, and only lessrisky projects undertaken to minimize financial risk. The choiceinvestment operational risk such as new involved practices, wouldaffect the business operations. This will determine its cost, in likemanner expected organization safety must be factored.
Whena particular project involves expected safety issues, a carefulsafety assessment must be done in order to identify potential riskand its appropriate management. An investor should use trials to knowthe potential risks and the best techniques of management (Saita,2007). These trials are worthwhile to unravel existing assumptionconcerning specific risk whether it is legitimate or not.
Costof capital refers to “the minimum required rate of return which afirm requires as a condition for undertaking an investment” (Porras& Palgrave, 2010). This capital is obtained from differentsources each having different cost. For instance the cost of sourcingfunds from equity shares differs significantly from capital raisedfrom preference shares. The specific cost is unique to each sourceand the average provides the general cost for sourcing capital.
Uponacquiring this capital the firms utilize it by investing in severalassets. This investment is funded such that the expected returns aremore than the cost of acquiring the funds. Therefore, the expectedminimum returns earned by the company should be equivalent to thecost used to acquire the capital. As a result, the cost of capital isviewed under as acquisition of funds and the use of funds (Porras &Palgrave, 2010).
Fromthe perspective of sourcing funds, the firm will try as much aspossible to limit its borrowing spree. On the perspective of fundsapplication, the firm will strive to its level best to attain therequired return rate. The cost of capital provides the averagereturn rate needed by the investors offering long-term funds (Porras& Palgrave, 2010). This in essence implies that a company mustattain a certain minimum rate of return from its capital in orderthat its market valuation of equity shareholders would not decline.
Capitalbudgeting is usually conducted without the consideration of thecognitive and emotional state of individuals and organizations. Thisdecision-making process lacks guidance and solely based on theassumptions that investors’ behavior is fully informed and rational(Goldberg& Nitzsch, 2001). But accepted and appropriate capital budgetingshould factor in its decision making process the emotional, cognitiveand institutional dimensions. This provides a more realistic andreliable context to interpret capital budgeting decisions.
Behavioralfinance implies that decision making process is dictated by thebehavior of investors that contribute to sought of unpredictablecapital budgeting. The choice of investment to undertake duringcapital budgeting process, to a large extent is motivated by thebehavior of the organization decision makers. During the assessmentof the different projects, the investors will incline to thoseinvestment projects with seemingly higher returns, yet failing tocapture the reality of these investments increased risks level(Goldberg & Nitzsch, 2001).
Thiswill contribute to irrational and poorly informed choices that willresult to unwise utility of the available startup capital. Thedecision may seem appropriate when only cash flow returns is factoredwithout analyzing the effect of other risk factors such as higherinitial capital, failure of payments and the delay of expected cashflow. In effect the firm will forego better projects with stable cashflow returns and lowered risk.
Thecompany will fail to analyze rationally all the possible investmentsprojects using capital budgeting techniques, but will be influencedby its behavioral aspects (Goldberg & Nitzsch, 2001). As such theorganizational and behavioral finance play a major part to determinethe type of project the company will select to invest.
Thefinancial ethics focuses more than the knowledge on value but inaddition elaborate the values of the respective actions. Financialmanagers and leaders are expected to seek deeper awareness ofrational and the respective constraints of institutions in a bid toground better their organization and business on ethical aspects(Boatright,2008). In the financial industry there have been a lot of scandalsthat involves financial professionals shortchanging the employers,peers and investors. The leading cause for the increased defraudcases is largely due to greed. This is contributed by unethicalbehaviors that control financial managers mainly due to minimalawareness of the basic concepts of the financial ethics.
Thisunethical behavior is due to short-term perception which complicatesthe exercise of the accepted code of conduct. Ethics offers supportto the organization’s set standard that ratifies its financialmanagement (Boatright, 2008). The shareholders may require themanagement not to engage in activities that are unethical to maximizeits profits, but due to an incomplete contract between shareholdersand the management, the management will override will shareholdersview. For instance this can happen if a pension firm invests byfinancing the building of a pipeline project using forced labour.This venture though it will maximize profits constitute to humanrights abuse (Boatright, 2008).
Financialprofessional with poor behavior are not trusted and this will makethe company impose stricter adherence of the ethical regulation. Thiswill cultivate an environment that is more expensive and cumbersomebecause everything ought to be litigated, enforced, agreed andnegotiated. And as such constitute to a higher transactional cost(Boatright, 2008).
Boatright,J. R. (2008). Ethics in finance. Malden, MA: Blackwell Pub.
Dayanada,D. (2002). Capital budgeting: Financial appraisal of investmentprojects. Cambridge, UK: Cambridge University Press.
Goldberg,J., & Nitzsch, R. . (2001). Behavioral finance. New York: JohnWiley.
Ong,M. K. (2006). Risk management: A modern perspective. Burlington, MA:Academic Press/Elsevier.
Porras,E. R., & Palgrave Connect (Online service). (2010). The cost ofcapital. Basingstoke: Palgrave Macmillan.
Saita,F. (2007). Value at risk and bank capital management. Amsterdam:Elsevier Academic Press.
Schutter,O. ., Swinnen, J. F. M., & Wouters, J. (2013). Foreign directinvestment and human development: The law and economics ofinternational investment agreements. Milton Park, Abingdon, Oxon:Routledge.
Ye,S., Wang, Y., Li, Y. (2009)International Conference on BusinessIntelligence and Financial Engineering (BIFE). (July 01, 2009).Investment Value of Convertible Bonds Based on Binary Tree. 338-341.