Capital Budgeting Techniques

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ABSTRACT

This report describes capital budgeting techniques such as NPV (The NPV of an investment is the difference between its market value and its cost, IRR (The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. PAYBACK (The payback period is the length of time until the sum of an investment’s cash flows equals its cost), discounted payback period (The discounted payback period is the length of time until the sum of an investment’s discounted cash flows equals its cost).

There are some notable differences between capital budgeting processes in developing and developed countries. Canadian firms tend to formally evaluate all investment opportunities, while US managers do a thorough analysis of only he large ones. In conclusion, the developing countries like Cyprus, and Pakistan, for the most part, do not follow scientific evaluation techniques for their investment projects probably due to lack of familiarity with such methods. From this research of developing countries it seems that the same trend is followed in all developing countries. These findings indicate the need for training and educating the managers of the firms in the capital Budgeting area of financial management. As for as developed countries are concerned they do use capital budgeting techniques.

INTRODUCTION

This report attempts to ascertain which criteria managers of developing countries like Cyprus and Pakistan and developed countries like USA and Canadian firms employ in capital budgeting decisions and whether these criteria differ between these countries. The capital budgeting analysis techniques we examine include IRR, NPV, Pay back Period, MIRR; because most managers use more than one method of evaluation. The first part of the report explains the meaning of budget and capital budgeting, definition of various techniques used in capital budgeting the second part shows the different capital budgeting processes used by developing and developed countries and the last section presents the conclusion of all research.

Background and Meaning
Budget:
In its simplest form, a budget is a planning tool that describes an entity's available resources and the way resources can be used to achieve the mission of the organization. It may also be viewed as a written form of communicating the future plans of the organization through the allocation of its resources [Troy’s study(As cited in the Norvell 1994, 23).] For public entities a budget may be used not only to help allocate resources but also to obtain funds [Post, Troy’s study (As cited in the Norvell 1994, 23).] Through identification of project costs, given varying assumptions, it can be used by policy makers to seek additional funding or resources. Indeed, it is not uncommon to find in grant applications the requirement of a budget to identify project costs and the means of supporting its operation. (Post, Troy, Economic Development Review; 1999, Vol. 16 Issue 2, p51, 3p )

Capital budgeting also involves the allocation of resources, but it generally encompasses large ticket items that could not be paid for with the resources available to an organization over a short period of time, such as a single year. Due to the dollar cost of items contained in a capital budget, more attention during the creation of a capital budget is focused on future trends affecting the organization and on the benefits and costs associated with each capital budget item [ Post, Troy’s study(As cited in the Reed and Swain 1990, 229).] No planner or financial officer wants to realize three years into a project that the budgeted item will not work, or is not needed, or can not be afforded. To avoid such situations, the analysis requires detailed information on the front end; it also requires continual input from several departments or divisions within an organization. The failure to integrate these divisions into the process may lead to...
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