ACCT-346 Week 7 Discussion: Capital Budgeting and the Time Value of Money

ACCT-346 Week 7 Discussion: Capital Budgeting and the Time Value of Money What is capital budgeting and why is it important to business decisions? Capital budgeting is a procedure that attempts to decide what's to come. Prior to the start of any extensive task, the capital budgeting procedure should be used. Without capital budgeting, an organization could make a drastic mistake. Choosing which venture or undertaking to put resources into is a long-term choice. An organization must consider that choosing to put resources into an undertaking will influence them positively or negatively for quite a while. Appropriate capital budgeting guarantees that the choices to contribute is made on just beneficial undertakings. Different capital budgeting decision guidelines, such as payback period, net present value method, certainty equivalent or the internal rate of return can be utilized to choose the most suitable venture to execute (Jain, Singh, & Yadav, 2013). Capital budgeting additionally includes choosing the venture that will amplify the estimation of the shareholders wealth. An organization should analyze all the cash flows of the various projects under consideration. They should discount the cash flows at a predetermined rate called cost of capital to adjust for risk and inflation. Then select the project that maximizes the shareholders’ wealth. Discuss how the information should be organized in a capital budgeting process, and who will use the information for decision-making. The organization of the capital budgeting process includes many different steps starting with the generation of good quality project ideas. Ideas can be generated through many sources like senior management, employees and functional divisions or even from outside the company (Froot & Stein, 1998). Next would be the basis of accepting or rejecting a capital project which is the project’s expected cash flows in the future. Hence, all the project proposals would be analyzed by forecasting their cash flows to determine the expected profitability of each project. Once the profitable projects are shortlisted, they would be prioritized according to the available company resources, a timing of the cash flows of the project and the overall strategic plan of the company. Some projects may be attractive on their own, but may not be a fit to the overall strategy. A follow up on all decisions is equally important in the capital budgeting process. The analysts compare the actual results of the projects to the projected ones and the project managers are responsible if the projections match or do not match the actual results. A post-audit to recognize systematic errors in the cash flow forecasting process is also essential as the capital budgeting process is as good as the inputs’ estimates into the forecasting model. Decisions are usually made by senior management; however, the capital budgeting process should involve stakeholders from all divisions of the company (Jain, Singh, & Yadav, 2013). What could go wrong with the capital budgeting process? Capital budgeting revolves around capital expenditures which include large inflow and outflow of money to finance investment projects. A wrong capital budgeting decision taken can affect the long-term durability of the company. Organizations also put their reputations on the line when they take on a major, multi-year, capital-intensive project. There is a long-term commitment of funds which increases the risk. The greater the risk involved, the greater the need for careful planning of capital budgeting. The capital budgeting decision is of irreversible nature and has a long-term significant effect on the profitability of a company. Not only the present earnings of the company are affected by the investments in capital assets but also the future growth and profitability of the company depends upon the investment decisions taken. Therefore, any unwise decision may prove disastrous and fatal to the very existence of the company. Provide an example of a capital budgeting process from an online source and explain the salient points of this example to the class. The Payback Period Method of capital budgeting is a pretty popular method, it works on the length of time it will take to recover the cost of the purchase from earned net income (after taxes). The payback period ignores the time value of money, unlike other methods of capital budgeting, such as net present value, internal rate of return or discounted cash flow (Webster, 1997). Example: Consider an old and inefficient piece of production equipment. Repair costs during the year amounted to $2000. In downtime, four production days were lost, which idled $800 in labor. A replacement model will save one main-day of labor or $400 in each quarter of a year. Total annual savings of $3200 through purchase could, theoretically, be attained. Since depreciation is a noncash expense, it is not customarily figured into the analysis. Cost of the replacement model is discovered to be $10,000, with a useful life expectancy of six years. Salvage value is estimated by the manufacturer to be 10% or $1000. Does it make business sense to pay $10000 to receive $3200 for a period of six years? A quick answer is found by calculating the payback period. Payback = Equipment Cost /Est. Annual saving=$10000/$3200=3.13 years In just over three of the six useful life years the equipment will be paid off and will provide an estimated $1000 salvage value toward value the equipment’s sixth year replacement. The approximate rate of return in this instance is 25%, which was estimated through use of a present value table (Webster, 1997). References Froot, K. A., & Stein, J. C. (1998). Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach. Journal of financial economics, 47(1), 55-82. Jain, P. K., Singh, S., & Yadav, S. S. (2013). Capital Budgeting Decisions. In Financial Management Practices (pp. 37-76). Springer India. Webster, A. (1997). Financial criteria, capital budgeting techniques, and risk analysis of manufacturing firms. Journal of Applied Business Research Laramie. Show Less