Capital Budgeting

Capital budgeting

Introduction

Capital budgeting techniques are used by the investors in order to ascertain the future prospects of a particular project. Different methods and techniques are used to assess the profitability of the budgets which will be carried out in future. Assessment is carried out in order to find out the future profitability of the project or investment and the expected rate of return (Bierman, 2012).

Capital budgeting decisions carries immense importance in the project sustainability carried out by any company. Cases have been reported where companies have been bankrupted or liquidated due to ineffective capital budgeting decisions they made at one particular time. Capital budgeting decisions are extremely important because on those decisions the future prospects of the company lies. Capital budgeting decisions provide a sense of direction and opportunity for future growth (Awomewe & Ogundele, 2008).

Discussion

The capital budget is the process of planning and management of long-term investments of the company. Through this process the organization managers seek to identify, develop and evaluate investment opportunities that may be profitable for the company. It can be said, in a very general, this evaluation is done by checking if the cash flows that generate investment in an asset exceed flows required to accomplish the project.

Example of capital budget

Year 1

Year 2

Year 3

Computer Equipment:

Computers

$ 45,000

$ 15,000

$ 15,000

Servers

$ 120,000

$ 25,000

$ 25,000

Support Service

$ 26,000

-

$ 29,000

Furniture and fixtures:

Office furniture

$ 28,000

$ 6,000

$ 6,000

Renovation Costs

U.S. $ 89,000

-

-

A poorly executed capital budget can bring very serious consequences for the company, just as a capital budget done correctly can bring many benefits. Investments in fixed assets for the purpose of growth or renewal of technology usually involve very significant disbursements in addition to these assets are acquired with the intention of staying for periods of time, often extending for five years or more.

A bad decision to invest in these assets can mean the difference between a successful business for several years and a company struggling to survive. For Commercial Company, for example, a capital budgeting decision would consider opening a new branch. Such decisions are transcendent because it will determine what the company will be in the future, so it should not intervene only to persons skilled in the area of finance, but is committed or responsible for all functional areas of the company.

The evaluation of the project is not sufficient to consider the flows that generate, nor the expenditure required to carry it out. Also to be considered the likelihood of cash flows, and the period in which flows present. In other words, the financial evaluation of the project should consider the magnitude, timing and risk of all relevant cash flows related to the project.

Comparing Capital Project Evaluation Methods

Net Present Value

NPV (Net Present Value) is technique which represents the dynamic investment analysis with the help of discounted cash flows. The NPV principle is primarily based on the fact that a value of dollar today is worth more than the value of dollar tomorrow. The profitability of the investment is assessed by the cash flows it ...