The Essay: Importance Of Capital Budgeting In Financial Planning.

The Importance of Capital Budgeting

Decisions are to be taken for many things in the company the matter can be major or minor. The responsibility of decision making lies in the hands of the management. The management is wholly responsible for the results of that decision making. Some of the examples where decision making is required are acceptance or repentance of a special order, investment decision, borrowing decision etc (Berman, Knight and Case, n.d.)..

We know that a company cannot survive without funds, whether small in nature or big. Therefore, it is important to carry out proper financial planning. A company needs several assets in order to grow, expand and earn profits but before investing in such asset it is important to know whether it is worth funding cash for these or not. This decision can be taken with the help of a method known as capital budgeting (Bruner, Eades and Schill, 2017).

Capital budgeting plays a major role in financial planning and therefore, it has its own importance. The importance of capital budgeting are (TULSIAN, 2016)-

1. This process helps to forecast the future cash inflows and outflows of a company which further helps to decide about the acceptance of a particular project.
2. The process of decision making is carried out at all the levels of the organisation and this process begins when there is an idea of a new project till this project is concluded. Hence, it is required at every time of the company’s working.
3. A company can grow, expand and compete well only when it has the ability to develop long term strategic goals. However, capital budgeting is a process which is helpful in setting these goals.
4. There are huge expenditures incurred in a company but it is always important to monitor and analyse the benefits of spending funds, this becomes easier with the help of the capital budgeting expenditure.

Capital budgeting is used by many companies as it is beneficial in taking long term decisions. However, this process also has certain limitation which a company should know before its adoption (Clarke and Clarke, 1990)-

1. Markets are dynamic in nature; therefore we can never now about the risk and uncertainty that may arise. Capital budgeting ignore the risk element and the uncertainty element (Fairhurst, 2015).
2. Capital budgeting takes into consideration certain financial factor, it complete ignore the non quantifiable factor such as reputation of the company, employee morale etc.
3. There is no guarantee that the decision taken through this process will be correct because capital budgeting is a process which takes future into consideration and no one is capable enough to predict the future (Taylor, 2008).
4. The capital investment decisions can also be limited by urgency.

Capital budgeting involves various methods and techniques. Firstly, let us now understand the method involved in capital budgeting-

Net present value- The value that is attained after deducting the cash inflows from the cash outflows is known as net present value. This formula helps to know whether there will be profitability or not and to what extent. A company thinks of accepting the offer when the NPV calculated is positive.

IRR- The attractiveness of the project is determined using the IRR method. IRR stands for internal rate of return. IRR can be defined as the rate of interest earned when the NPV of the future cash flows is equal to zero. An investor while investing has a required rate of return in his mind (Galbraith, Downey and Kates, 2002). However, if the required rate of return is more than the actual IRR that has been calculated then the investor may not invest there. In this case when the required rate of return is less when compared to the IRR then the investor will surely invest as he is getting more than his requirements.

Limitations of Capital Budgeting

There are various other method in the capital budgeting such as payback period method, profitability index, Real options valuation etc (Shim and Siegel, 2008).

As discussed earlier there are also certain techniques involved in capital budgeting. Like- Sensitivity analysis, breakeven analysis, Scenario analysis and simulation analysis.

Sensitivity Analysis

This analysis is basically performed to determine the effect of change in one variable on the other variables. The various alternate outcomes of a particular project on the basis of different assumptions can be determined with the help of sensitivity analysis. This analysis is also popularly known as the what if analysis. A company forecasts a result beforehand when the actual result is out the company uses this technique to measure the deviation and tries to figure out the reason behind it. When the reason is identified than the company takes corrective measures which help them to rectify their mistake in future and take better decisions.

Let us consider few examples to understand sensitivity analysis deeply:

Example-  Suppose there is a company that is expecting to earn profits of $1000 for three consecutive years. As the investors are pretty sure that the company will be able to generate such revenues they have agrees to invest $3000 at the beginning itself. But it was observed at the end of the first year that the company would generate more than expected say $1500 for the remaining two years. This would break even the investment in the second year itself. So, we can conclude that this analysis plays a major role in making us understand the various effects that a change could have (Hassani, 2016).

Example- This example will let us know that why is it also known as “what if analysis”. Every company has a sales manager whose work is to look after the sales of the company and if the sales go down then find out the reason for. This sales manager is keen to know the impact of the increasing customer base in the company. As we know, that the basic functions of sales are the price of goods and transaction value. After studying the consumer behaviour he drew a conclusion that a 10% change in the customer base could increase the revenues of the company by 5%. So this question “what if the customer base increases by 10% ? is resolved using this approach (Holland and Torregrosa, 2008).

It is a very known fact that we cannot predict the happenings keeping in mind the dynamic and uncertain nature of the markets today. The analyst should always consider this analysis as analytical tool. The analyst usually uses the words best case, base case and worst case in order to explain the outcomes. It is well understood by the words itself that the best case is the one in which all the things go in the way in which the analyst thought it to be whereas the worst case is just the opposite of the best case. Anything that has the highest probability is considered as the base case. It is the task of the analyst to identify the risk and also prevent the worst case scenario. However, it is a fact that the analysis cannot provide the exact situation but it provides a rough idea so that further steps can be taken with utmost care (Khan and Jain, 2014).

Methods involved in Capital Budgeting

 We know that estimations are never accurate they always differ from the actual data. But the analyst tries his best that his estimation falls close to the actual data. However, if there are any confusions or uncertainties then the sensitivity analysis is not enough, it has to be extended to scenario analysis (Saunders and Cornett, 2017). While performing scenario analysis the analyst may use the sensitivity analysis also but there never arises situation when an analyst requires scenario analysis information while carrying out sensitivity analysis. Scenario analysis is basically done to analyse the uncertainties that may arise and the impact of this uncertainty on a particular project. Scenario analysis and sensitivity analysis goes hand in hand and are considered very vital part of the capital budgeting process. These tools not only gives advise for the best investment plan but also saves them from the dynamic nature and the risk involved in the market (Palepu, Healy and Peek, 2016).

A company has to incur cost in order to manufacture and sell the product in the market. Cost is included in the manufacturing process and even in the selling and distribution process. These costs may be variable and fixed in nature. A company is said to earn profits only when it has recovered the entire cost from customers. The level at which the company only recovers the cost and does not have any profit or loss is known as the breakeven point (Phillips, 2014). We can also say that the net income of the company will be equal to zero in such a situation. There are two different formulas of breakeven point, one helps to know about the breakeven point in units whereas the other gives the breakeven point in term of volume of sale. A lower breakeven point is considered beneficial for the company.

According to the accounting breakeven point, total cost will be equal to the total revenue and net income will be equal to zero. The two formulas of breakeven point are shown below (Reilly and Brown, 2012):

Breakeven point (in units)= Fixed cost/ contribution per unit

Breakeven point (sales volume) = Fixed cost / Contribution margin

However, if the amount of depreciation is excluded from the fixed cost then we get the cash breakeven point for the company.

In case of the financial breakeven analysis, the initial payment made towards the investment is always equal to the future cash inflows and therefore, the NPV is zero,

Example-

Variable cost= 60000, Fixed cost =90000, Depreciation =10000,

Sales for the year =80000, Number of units=10000

Therfore, contribution = Sales – Variable cost

Contribution =20000

Contribution margin = Contribution / Sales*100

Comtribution =20000/80000*100 = 25%

Breakeven point (units) = 90000/2 =45000 units

Breakeven point (sales volume) = 90000/25% = $360000.

Cash breakven point= 90000-10000/25% = $ 320000

The word “simulation” itself means acting of something or pretending to be someone. Therefore, the work of the analysis is to produce an outcome shoeing the different probabilities of the outcome and showing interaction between different variables. It becomes convenient for an analyst to take investment decisions through this analysis (Saltelli, Chan and Scott, 2008). The outcomes that are derived from this analysis are infinite. An analyst takes into consideration many other factors also before applying this technique.

1. The first step is to analyse the relationship between the present value and the parameters. As we know parameters are constant they act as a benchmark.
2. The probabilities are then assigned to the random variables depending on the parameters.
3. Select any one variable randomly to which the probability has already been assigned.
4. Then the NPV should be calculated for the given set of variables.
5. Then NPV is calculated for the required outcomes. However, it is noticed that there is not a particular outcome nut there are several outcomes.

All these four techniques are considered the most important part of the capital budgeting process.

References:

Berman, K., Knight, J. and Case, J. (n.d.). Financial intelligence for HR professionals.

Bruner, R., Eades, K. and Schill, M. (2017). Case studies in finance. Dubuque, IA: McGraw-Hill Education.

Clarke, R. and Clarke, R. (1990). Strategic financial management. Homewood, Ill.: R.D. Irwin.

Fairhurst, D. (2015). Using Excel for Business Analysis A Guide to Financial Modelling Fundamenta. John Wiley & Sons.

Galbraith, J., Downey, D. and Kates, A. (2002). Designing dynamic organizations. New York: AMACOM.

Hassani, B. (2016). Scenario analysis in risk management. Cham: Springer International Publishing.

Holland, J. and Torregrosa, D. (2008). Capital budgeting. [Washington, D.C.]: Congress of the U.S., Congressional Budget Office.

Khan, M. and Jain, P. (2014). Financial management. New Delhi: McGraw Hill Education.

Palepu, K., Healy, P. and Peek, E. (2016). Business analysis and valuation. Andover, Hampshire, United Kingdom: Cengage Learning EMEA.

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Saunders, A. and Cornett, M. (2017). Financial institutions management. New York: McGraw-Hill Education.

Shim, J. and Siegel, J. (2008). Financial management. Hauppauge, N.Y.: Barron's Educational Series.

Taylor, S. (2008). Modelling financial time series. New Jersey: World Scientific.