Question

Select an SME and using a combination of primary and secondary data, assess the manner in which management makes capital budgeting decisions. Based on your findings, make recommendations to the management team on how it can improve the capital budgeting process.

Answer 1

Solution:

Capital budgeting is used by companies to evaluate major projects and investments, such as new plants or equipment. The process involves analyzing a project's cash inflows and outflows to determine whether the expected return meets a set benchmark.

When making capital budget decisions, companies focus on cash flows instead of accounting profits as accounting profits do not consider the time value of money, risk and return and valuation. By using cash flows it ensures that projects which are proposed are consistent with a company’s goal of maximizing shareholder wealth. When assessing a project it is normal to use cash flows rather than profits that arise out of the project .By using cash flow evaluation techniques it helps on assessing whether a project is viable and it offers the ability to rank competing projects.

Well, Management can improve the capital budgeting decision by comparing and contrasting the three discounted cash flow criteria (NPV, PI and IRR)

The Net Present Value (NPV) method of capital budgeting concentrates on the profitability of a project and it also considers the opportunity cost of money .NPV assumes minimum opportunity cost which means that the opportunity cost of the current project would be the return on a hypothetical alternative project that only covers the cost of capital. If the NPV is greater than $0, the project should be accepted, if the NPV is less than $0, the project should be rejected.

The limitations of NPV is that the choice of interest rate may be seen as subjective. Selecting an appropriate rate to use may depend on the cost of capital and also on the possible risk of the investment. However, capital projects are generally considered long term investments and the potential risk sometimes may not be known, for instance an external factor such as deterioration of the economic climate which may change quickly or unexpectedly

The profitability index (PI), provides a relative measure of a projects viability in comparison with NPV which provides an absolute measure . The PI is employed to differentiate the initial cash outlay from cash inflows in later years. For example, if a company has budgetary constraints, proposals of different value can be ranked and compared to make a decision on what project should be selected. The PI can be used as a method of ranking projects in descending order of attractiveness. A project proposal with a PI equal to or greater than 1.0 should be accepted and a project with a PI of less the 1.0 should be rejected.

The internal rate of return (IRR) assumes maximum opportunity cost which means that the maximum cost of capital could sustain and still be considered acceptable. The IRR is the discount rate that equates the PV of the net cash inflows with the initial outlay of the project, therefore using a NPV of the investment opportunity of $0.