Introduction
Capital budgeting is a significant concept in businesses that enables the selection of projects that will bring value. It involves a wide range of budgeting processes, including decisions on purchasing assets, acquiring land, or buying new machinery. Company decision-makers analyze the profitability of investment alongside putting into consideration its affordability basing on the financial position of the organization. Generally, capital budgeting is a determination of the project’s worthiness and examines if the project can return capital invested and generate more profits. The paper will explore the capital budgeting practices and the criteria used in the evaluation of investment. Besides, it will conduct a critic on whether profitability is the appropriate criterion in evaluating an investment proposal.
Capital budgeting practices
Capital budgeting decisions involve different practices and valuations methods in accepting or rejecting an investment (Alles et al. 2021, p.994). The following are the common budgeting practices commonly used;
Payback period
The payback time is a term used in the description of how long it will take for a certain project to recover back the initial invested capital, also called the liquidity of the investment. This technique allows managers to conduct analysis and compare alternative investments hence deciding on projects that will bring returns in the shortest period possible. Although the evaluation of the payback period does not offer a detailed analysis of the project, it provides certain perspectives on capital budgeting (Brown, 2021, pp.244-269). Moreover, some investors will not offer to fund a project if the payback time exceeds their set timetable. The formula used in the calculation is expressed as follows:
- Payback period= Initial investment/ Annual net cash inflow estimate
Its expression is given in years, and its calculation and application are easy.
Advantages
- It is simple and easy to calculate and understand.
- Payback period is useful in the situation of uncertainty.
- It keeps financial liquidity.
Disadvantages
- It ignores the time value of money.
- Focuses on the payback period.
- Payback period ignores the profitability of a project.
- It only considers the short-term cash flow.
- Investments of a company are not assessed properly.
Net present value
This capital budgeting technique is useful in establishing a profitable investment in the business. It compares projects while basing on their expected rate of return and anticipated revenue over some time. Calculation of this technique involves determining the correct discount rate by estimating cash flow for each period (Blaset Kastro et al. 2020, p.80). When the results of the net present value are positive means that the investment will be profitable and a good investment option (Burgos et al. 2020, p.70). This capital budgeting practice has the assumption that a negative net present value results in a profitable project while a negative value depicts a net loss in the investment.
Advantages
- It recognizes the time value of money.
- Easy in its calculation.
- It illustrates if the investment will bring value.
- It puts into consideration the cost of capital and risks factors of a company.
Disadvantages
- Net present value is not appropriate during a comparison of investments having different sizes.
- The calculation accuracy relies on the input quality.
- Typically focuses on short-term investments.
Internal rate of return
This practice allows for calculations and analysis of a certain investment by computing the expected growth rate of the investment returns expressed as a percentage (Davydenko & Skryphyk, 2017, pp.103-107). It is a discounting cash flow that gives the rate of return made by an investment. Generally, the higher the IRR exceeding the capital cost, the greater net cash flow coming to the company (Ilyash et al. 2020, pp.95-113). It is considered a profitable investment, and the company managers have to proceed with the project. When the IRR is lower as compared to the cost of capital, the best action by the decision-makers is to forego the project.
Advantages
- It is simple to use and understand.
- IRR incorporates the time value of money in its calculation.
- It takes into account the cash inflows and outflows in the company.
Disadvantages
- IRR ignores the economies of scale.
- It involves tedious computation.
- It can depict an incomplete future of the investment.
Challenges and problems faced when implementing capital budgeting techniques
Implementing capital budgeting involves balancing the risks involved against the project’s anticipated return (Isai et al. 2021, p.95). Several challenges and problems are faced by business financial experts in the implementation and they include:
Uncertainty of variables
Capital budgeting involves the use of several variables in its calculation to obtain the right capital position of the business (Manjunath & Praveen. 2020, p.340). Some of the variables can be uncertain, for instance, cash flow, tax rates can change, inflation rate, and technological changes can occur. Profitability index use, for instance, has its challenges. First, it is difficult to understand the discount and interest rate as this approach involves the use of guesswork on estimating the future cash flow by use of the present information (Senthilnathan.2020, p. 120). Moreover, it may not give the right decision in comparing mutually exclusive projects where they have different initial capital.
Lack of adequate information on the available investment opportunities
Financial experts in various companies without the right information on investment end up making wrong decisions (Siskos & Zopounidis. 2018, p.310). Emerging markets have some risks that the investors have to be aware of before channeling capital, before investing, there is a need to evaluate the risks to be involved in the project (Mishchuk. 2020, p.52). Managers have to conduct both external and internal research, for instance, if the organization wants to invest in an IT-related project, it will consider consulting an IT department in the company to get the right information on a project.
Not using the right budgeting method
This is another challenge that can be witnessed in the implementation of capital budgeting. There are different methods present, and not all fit all the scenarios, which can result in the wrong projection of an investment (Shvetsova et al. 2018.p.920). Financial decision-makers of a company have to be keen and obtain the correct method that will work well in every situation.
Decisions on capital budgeting are long-term and usually irreversible
When wrong decisions on a project are made adversely impacts the success of the investment in the future. Capital budgeting implementations plans have to include the source of funding for the project, the steps of recording the net income and benefits generated by the project (Sarwary, 2020, p.65). Besides, the implementation plan should include key project milestones, the timeline, and the completion date.
In conclusion, corporations are required to undertake investments that bring productivity to the business and increases shareholders’ wealth. The use of appropriate capital budgeting techniques is significant in making investment decisions by an organization. Financial experts should also follow the right criteria in the evaluation of an investment for the organization. Effective decision-making on the appropriate investment opportunity to consider gives the best results for the business.
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