Capital Budgeting Technique
All the Important Tips for Capital Budgeting Technique
Every company needs to make investments for reaping benefits from it. Companies make investment in various resources for the growth of business. Thus it is essential for the organization to appropriately analyze the project or investment opportunity before putting money into it. Firms need to analyze whether they will be able to make profits from the investment or not, or what will be the payback period of the project. In certain cases, for performing the same activity,
management have option to choose from various alternatives. In such situations, it becomes very complicated for the management to make effective judgment as profitability of the company depends on the strategic investment decision taken by the organization (Toit and Pienaar, 2005). For this purpose, capital budgeting is the best tool in the hands of management among all the investment decision tools, which assists managers to select the best investment option.
Capital Budgeting can be defined as a process which enables the companies to assess how to invest their capital for profit maximization. For growth, expansion and diversification of the firm, it is essential for the companies to keep on investing their capital into newer or existing projects and investment opportunities. Capital budgeting supports various parameters such as decisions related to putting money in new projects reassess the volume of money invested in an existing project, rational and allocation of funds in various departments of the company and acquiring some other entity (Khamees and et. al., 2010). In nut shell, it can be said that capital budgeting is a process that defines volume of company’s real assets which enable the firm to generate cash flows on the basis of which, parameters such as value, profitability and viability of the firm can be determined.
The basic principle which organizations’ follow before putting money into any project is to determine whether that particular investment will increase the wealth or value of the shareholders of the company or not. On assessment if the management finds that the reticular investment will enhance the value of its shareholder, the company will definitely go with the project if other parameters are feasible. On the other hand, if there will be no increase in the wealth in of its shareholder, then it is better to drop the project and rather put that money on some other project (Maccarrone, 1996). For example, one of the best tools of capital budgeting, Net Present Value (NPV) assists the manager in assessing the value which the new project is going to create for the company. If the net present value of the investment comes out to be positive, company can think of moving ahead with the project, on the contrary, if the net present value of the project comes out to be negative, in that case it is not advisable for the organization to invest in the project.
According to Graham and Harvey (2001), the net present value method of capital budgeting has gained popularity after 1951 when it was formally introduced by Dean. This method is widely followed by many of the organizations across the world, still one cannot eliminate the human element from the process of capital budgeting. The estimation of future cash flow from the project and the rate at which the project should be discounted generally varies from person to person as these are subjective process and largely depends on the behavioural characteristics of the managers (Szpiro and Dimnik, 1996).
For successful completion of any research it is important for the researcher to review as much literature available in the market. This will enhance the knowledge of the researcher on the research and the scholar will be able to identify the gap existing in the present studies. This section of current work discusses various techniques of capital budgeting used by the UK companies in appraising their investment. In addition, it will also analyze the role of strategy in decision making regarding investments.
All the projects related to capital investments are operational in nature and are strategically get more focus from the management. Such projects are characterized by high level of risk, high investment requirements and are difficult to quantify in terms of outcomes. Further, these strategic projects have long term implications on the performance of the corporate (Bazerman, 2006). Some of the examples of operational or strategic projects are mergers and acquisitions, purchase of new machinery or instalment of manufacturing process, introduction of new product line, modernizing of existing production or manufacturing unit, introduction of business units, increase in production capacity of the plant, etc (Bazerman, 2006).
All such projects are very complex in nature as all the times they are surrounded by uncertainty or investment and returns. Thus, evaluation of such projects is the main challenge for the accounting and financial managers in the company. Many studies have found out that relying only on the investment appraisal tools have resulted into biasness in the decisions of the decision makers in majority of the cases against projects which requires huge amount of investments (Bierman and Smidt, 1993). This has in some way stagnant the capability and innovations in the development of businesses. There are various empirical studies conducted in this field that discuss capital investment and decision making (Bierman and Smidt, 1993). Every financial and accounting manager know how much it is important for an organization to focus on investment appraisal tools, yet not much work has been done in this regards. This area of finance has always been ignored and very little development has taken place till date in relation to the assessment of such uncertain and complex processes. In the following paragraphs various techniques used by the UK manufacturing companies for evaluating the capital investment projects are discussed (Bierman and Smidt, 1993). \
The chapter three of the research report focuses on the theoretical concepts that assist in entire process of research. There are various techniques that can be adopted by the researcher for simplifying the study procedure. The main motive behind writing this chapter is to collect valid, authentic and reliable information so that final findings of the work can be justified. Further, it also explains the potential significance and limitations of the study (Alkins, 2010). Generally, it is quite difficult to analyse the collected data, but if the researcher follows appropriate methodology, it becomes very easy for investigator to come up with the findings and recommendations. Thus, has lot of significance on the entire study.
The present work focuses to determine the process of capital budgeting and popularity of different investment appraisal methods that are frequently adopted by the managers of the companies operating in the manufacturing sector of the United Kingdom.Thus, the research methodology section is formulated in such a manner that the researcher can properly conduct the work on the given area.
Earlier there were two kinds of research philosophy, Interpretivism and Positivism philosophy of research. In case of former, scientific sources are used for collection of data and the information accumulated is genuine and acceptable. That is why it is popularly known as scientific philosophy also. Scientific sources of data are can be sensory experience, mathematical treatment or logical treatment (Cavaye, 2008). The philosophy of Positivism is applicable on entire society and it states that only general laws are applicable on the society and it cannot operate on the basis of intuitive or introspective knowledge. This philosophy is applicable in case of large sample size. Contrary to this philosophy is Interpretivism. According to this belief, it is not possible to implement same concepts on all the situations of the life. That is, there is different concept for different situations and thus it operates on the principle that states both society and nature are two distinct objects and it is not possible to inter mix both the two processes. Unlike theory of Positivism, this approach is applicable on the small sample size (Cavaye, 2008).
In the present study a snapshot description of various empirical studies have been discussed pointing out the major findings of the work in relation to the capital budgeting techniques implemented by the manufacturing companies of the United Kingdom.
Various empirical studies have been performed to evaluate the techniques of capital budgeting employed by the firms of the United Kingdom while appraising their investment decisions. The main aim behind conducting this work was to find the process of capital budgeting and popularity of different investment appraisal methods in the United Kingdom. For this purpose, the study focused on the companies operating in the manufacturing sector of the United Kingdom.
To remain competitive in the existing business scenario, it becomes very important for not only the manufacturing companies but all the firms to keep on investing on technology and innovation. Further, to keep their operations up to dated, there are various investment options available to an organisation to choose from. Thus the main problem lies in the selection of the most suitable investment opportunity, because investment decisions are very complex in nature and involves higher degree of uncertainty regarding investment and return, and are associated with higher amount of risk. Therefore, it is very challenging for the financial and accounts manager to evaluate such opportunities. Further, if the management is not able to assess all the options correctly, it may stagnant its growth and development.
Capital budgeting is one of the main tools for the management and the financial managers to evaluate various investment options available to them so that they can put their capital on the most appropriate project that will generate higher returns and will be the most profitable for the business. There are various capital budgeting techniques, but among all, four methods are widely used by the managers of various companies operating in different sectors, these are; Payback Period, Accounting Rate of Return (ARR), Internal Rate of Return (IRR) and Net Present Value (NPV). Among these four techniques, ARR and Payback Period does not considers the concept of time value of money, on the other hand, the remaining two, that is, NPV and IRR are based on the time value of money concept. Thus, the later tow techniques are practiced more by the managers in comparison to the former two techniques.
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