Capital budgeting is a process that at least every business manager is aware of, and it involves selecting and evaluating projects. The projects involved in capital budgeting include those undertakings that increase sales, profits, and share price of an organization. Such projects also require firms to spend huge sums of money, and for this reason, they are highly risky (Roberts, 2011). The fact that the projects require huge sums of money also means that they last for several years, such that they can increase the value of a firm permanently. These are the factors that make capital budgeting decisions critical to organizations, and they need to be handled by highly skilled staff.
Organizations managers need to carry out the process of choosing projects carefully because they require huge capital outlay, and the loss of the funds may lead to severe consequences. The projects may be in the form of the purchase of new machinery or replacement of outdated assets. The assets are mainly those that carry out the most essential process in an organization, for example, a milk processor in a firm that manufactures dairy products. These assets are usually expensive because they involve transaction costs such as taxes, transportation, installation, and maintenance. Companies usually borrow funds to invest in these projects because they cannot raise all the required funds. Loss of the funds would, therefore, affect both the company and the creditors. An organization becomes bankrupt and insolvent once it loses the funds, and this may lead to closure of the firm. Managers, therefore, need to plan efficiently to ensure that they do not lose the funds that they invest in the projects.
Projects involved in capital budgeting are usually complex, risky, and associated with high returns. The complexity of the undertakings requires highly skilled personnel to carry out the budgeting process. The process involves predicting costs and returns that would be produced in case the project is implemented and comparing the benefits of different schemes. These processes are carried out using complex techniques such as regression, net present value, and profitability index. Organizations that employ unqualified staff to carry out the process may face consequences that would otherwise not occur. The consequences include huge debts, low sales and profits, loss of assets, and legal suits (Roberts, 2011). The unskilled workers may also advise a company to invest in a project that is less profitable than others. This leads to wastage of funds in future because the firm would have to acquire the asset that maximizes wealth. Shareholders may withdraw their funds from an organization if they discover that their funds are wasted rather than being utilized efficiently to maximize their wealth. Managers, therefore, need to employ qualified staff to carry out the complex processes involved in capital budgeting.
The Net Present Value (NPV) is a technique that helps managers in choosing investment projects. The method analyzes the future benefits and costs associated with different projects; managers then choose the plan that leads to the highest profits among those under study. Researchers have found out that Net Present Value approach is superior to other techniques for several reasons. The reasons include taking into consideration the time value of money, incremental benefits, and the use of discounting rates that do not change the market value of assets (Roberts, 2011).
The technique recognizes that the value of money changes with time, for example, one hundred dollars may purchase greater quantities of a good in 2013 than in 2014. This difference means that the value of one hundred dollars is greater this year than it will be next year. Net present value method, therefore, uses a discounting rate to determine the value of cash inflows and outflows of a project in different periods. The differences present values of funds results from varying factors such as taxes and inflation. Organizations interested in finding out the projects to invest in do not have to worry about the effects of taxation and inflation when choosing projects. The consideration of the time value of money makes this technique superior to the accounting rate of return and payback period; these methods assume that the value of wealth is constant from one period to the other.
Net present Value is easy to calculate, and it allows managers to compare different projects. This is because the technique advises managers to invest in projects that produce positive NPV. Managers compare NPVs of projects for certain periods, for example, two years; the leaders choose to undertake the plan that leads to the highest Net Present Value. Organizations may alter the discount rate used in the technique according to the factors that their business experience. An example of this may take place when the risks facing an institution increase (Pratt and Grabowski, 2011). In this case, managers would increase the discounting rate so that it can take care of the additional threats facing the organization. This is according to the philosophy of investment, which argues that investors should increase the rate of benefits that they expect from a venture when risks are high.
The management of a firm should consider non-financial information such as federal policies, effects of the asset to the environment, durability, availability of complementary resources and space, and acceptability of the project in the society (Gropelli and Nikbakht, 20120). These factors also determine whether a project will be successful. Organizations need not ignore these factors because may lead to negative consequences such as closure of business, loss of customers, sales, and profits.
The durability of the asset under consideration is essential because it determines whether the project will last until the end of its economic life. Durable assets are preferable because they are less costly to maintain than non-durable equipments. Companies get higher returns from durable assets than non-durable properties. This is because non-durable assets may depreciate before the end of their economic life. When such an occurrence takes place, the management of a firm is forced to spend funds on replacing the asset. The increase in costs reduces the returns of a company. Leaders of organizations should, therefore, ensure that they purchase long lasting assets.
The federal laws are also critical when making capital budgeting decisions because they govern the purchase, production, and sale of products to consumers. Managers need to consider the laws that relate to the project that they invest in to ensure that they undertake lawfully accepted schemes (Bierman, 2010).
Organizations should also consider the effects of projects on the society. These effects include pollution, non-acceptance, and employment. The project should be accepted by majority of the members in a society because this guarantees consumption of the final product (Gropelli and Nikbakht, 20120). The society accepts projects that do not pollute the environment and creates employment for the youth. Managers should choose projects that meet the society’s standards. This does not only make the project acceptable, but it also increases the returns that the firm gains from the investment.
The management of a company should also consider whether the project requires highly skilled personnel. This is because some projects may be profitable, but lack of skills may lead to non-utilization of the asset. Availability of skills means that the firm does not incur costs of training employees, and this leads to high profits. Lack of skilled staff, on the other hand, leads to high cost of training workers, which consequently leads to low returns. Managers should ensure that they purchase equipments that require locally available skills to minimize cost of production.
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