Capital budgeting decisions
This feature is a continuation of an earlier publication on how managers could effectively strategise and manage complex investment decisions to ensure profitability of their respective firms. Discussions in the previous write-up ended on some factors affecting capital budgeting decisions.
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A common belief held among some finance experts is, the decision to invest is greatly influenced by the relationship between projects: whether they are independent, mutually exclusive, complementary, contingent, or substitutes. Independent projects have no connectivity.
Examples include the decision to purchase and install machines for baking bread. Mutually exclusive projects are those that provide alternatives.
For instance, a construction company that is interested in purchasing tractors could choose between tractors whose engines are electrically controlled or gas controlled.
Some projects may be complementary in nature. For example, a firm that is interested in enhancing its operating performance in all departments may take the necessary steps to improve its lighting systems.
Projects are termed as contingent when they are required to be executed collectively, or not at all. For instance, if establishing a supermarket requires a parking lot for customer, then the supermarket and parking lot should be considered as one contingent project.
Substitute projects are those whose introduction tends to impact on existing ones. For example, the introduction of new wheat bread would adversely affect the sales of existing white bread in certain areas.
Identification of the relationship between projects helps firms in prioritising their investment procedures.
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Administrative processes
Although most companies are able to develop many proposals for projects, they do not have the requisite funds to successfully carryout those projects. Stated differently, non-availability of funds poses a strong challenge to firms’ transformation of imaginary projects into actionable ones. Indeed, not all project proposals may be useful – some may be good, others may be bad. Therefore, it behooves the firms to device strategies that would help identify good and productive projects from bad ones. Firms could rank projects and determine minimum requirements for each.
Board’s decision
Generally, proposals for projects with huge capital outlay may require the approval of individuals occupying higher positions in the company. Essentially, the board of directors is responsible for the approval of significant investment capital required for the implementation of a capital budgeting programme. Their approval is also required for the entire budget for specific planning periods.
Decisions of the board in this regard are very vital in defining the financial exploits and success of the company in subsequent years. For capital budgeting programmes to be successful, it is necessary for management to review and evaluate capital budgeting decisions on a periodic basis. Thus, it is essential for the finance department to work in collaboration with various departments to collate reliable data that would facilitate the effective analysis of all investment projects in the organisation.
Capital budgeting methods
Decisions related to capital budgeting are intended to increase the wealth of the company. Generally, the capital budgeting process helps the firm in selecting desirable projects from a set of mutually exclusive ones. It also facilitates the firm’s decision on the number of projects that should be adopted and implemented. In their bid to effectively explain the rules pertaining to investment decisions, seminal writers such as Copeland and Weston (1983) and Weston and Copeland (1992) outline the following assumptions:
• There are no errors in the estimation of the stream of cash flows.
• We know about the cost of capital or opportunity cost of funds that is given to the company.
• Corporate managers are able to separate investment decisions from the preferences of individual shareholders. This is made possible by the lack of friction in the capital markets.
• Corporate managers are able to maximise the stock price of the firm because costs of monitoring are zero.
• Managers only need to know about the stream of cash flows, and the rate of return required in the market for projects that have equal risk.
Capital budgeting methods have a relationship with rules pertaining to investment decisions. Some capital budgeting methods that have been identified, and are widely used include the Accounting Rate of Return (ARR), Cash Payback (CP), Discounted Cash Payback (DCP), Net Present Value (NPV), Internal Rate of Return (IRR), Net Terminal Value (NTV), Opportunity Cost Return (OCR), Profitability Index (PI), and Perpetuity Rate of Return (PRR). The most preferred method is the one that would ensure maximization of shareowners’ wealth.
The best method would elicit the following four essential features:
1. Consideration would be given to all streams of cash flows.
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2. The stream of cash flows would be discounted at the cost of capital determined by the market.
3. The method would result in the selection, from a list of mutually exclusive projects, the one that maximises the wealth of shareowners.
4. Managers would be able to consider each project independently from all others. This feature is commonly referred to as the value additivity principle.
The value additivity principle posits that the value of the firm could be determined (1) if the value of independent project approved by the firm is known, and (2) if the values of the approved projects are added together. Suppose the firm has N accepted projects. Mathematically, the value of the firm would be
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Where:
V = Value of the firm
Σ = Sum of all present values of the projects
Vj = Value of the projects
N = Number of accepted projects
If we assume that the firm has five projects, then
The importance of the value additivity principle lies in its ability to help management consider each project on its own merits without necessarily having to look at it from the perspective of varied and endless combinations with other projects. The main objective of the financial analyst is to select the method that satisfies all the four capital budgeting characteristics outlined in the preceding discussion, and which maximises the firm’s stock price.
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If we assume that the firm’s cash flows are known with certainty and selected projects have equal risk, then we can determine the capital budgeting method that maximises the firm’s stock price.
Cash flows can be described as the residual amount of money ready to be distributed to investors after the requisite investments in working capital for day-to-day operations; and investments in fixed assets have been duly made by the firm. The foregoing definition indicates the value of the firm is largely influenced by the stream of cash flows from its operations today, and in the future.
Capital budgeting decisions are essentially based on future cash flows, not accounting net income. Accounting net income is mostly derived from discretionary depreciation rates adopted by accountants; it is determined after interest expenses have been deducted.
This argument lends credence to Copeland and Weston’s (1983) submission that there is a distinction between economic and accounting profits. Arguments of the various financial experts seem to affirm the relevance of economic profit over accounting profit.
The data in Table 1 depict the stream of cash flows for four mutually exclusive projects. The data show initial investment capital of $1,500 and estimated life of five years for each of the four projects.
An investment into the selected project cannot be redeemed, if it is abandoned after its inception. Thus, the final selection of projects requires due diligence and careful analysis of all alternatives.
The writer is the Dean / Senior Lecturer
Regent Univ. College of
Science and Technology
He is also the consultant
Eben Consultancy
Email: [email protected]; [email protected]
Website: www.ebenezerashley.com