Capital Budgeting: Advantages and Limitations
CAPITAL BUDGETING: ADVANTAGES AND LIMITATIONS.
SEPTEMBER 2012
CHAPTER ONE
INTRODUCTION
1.0 Background Study
Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new projects, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions, and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability.
In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of the firm’s shareholders. For example, the Net Present Value (NPV) rule specifies an objective process by which firms can assess the value that new capital investments are expected to create. As Graham and Harvey (2001) document this rule has steadily gained in popularity since Dean (1951) formally introduced it, but its widespread use has not eliminated the human element in capital budgeting. Because the estimation of a project’s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioural traits of managers still affect this process.
Capital budgeting is a process that is used to determine whether or not certain projects are worthwhile investments. Another term for capital budgeting is called an “investment appraisal.” Every firm has both a limited amount of capital available and a desire to deploy that capital in the most effective way possible. When a firm is looking at, for example, acquisitions of other firms, development of new lines of business or major purchases of plants and equipment, capital budgeting is the method used to determine
SEPTEMBER 2012
CHAPTER ONE
INTRODUCTION
1.0 Background Study
Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new projects, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions, and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm’s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability.
In principle, a firm’s decision to invest in a new project should be made according to whether the project increases the wealth of the firm’s shareholders. For example, the Net Present Value (NPV) rule specifies an objective process by which firms can assess the value that new capital investments are expected to create. As Graham and Harvey (2001) document this rule has steadily gained in popularity since Dean (1951) formally introduced it, but its widespread use has not eliminated the human element in capital budgeting. Because the estimation of a project’s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioural traits of managers still affect this process.
Capital budgeting is a process that is used to determine whether or not certain projects are worthwhile investments. Another term for capital budgeting is called an “investment appraisal.” Every firm has both a limited amount of capital available and a desire to deploy that capital in the most effective way possible. When a firm is looking at, for example, acquisitions of other firms, development of new lines of business or major purchases of plants and equipment, capital budgeting is the method used to determine
References: Brehmer, Berndt (1980). “In One Word: Not From Experience.” Acta Psychological 45:1-3, pp 223-241 Brian Baldwin (1997) Cooper, William D. Morgan et al (2001), Margart Business Forum (online). Available from http://www.entrepreneur.com/tradejournals/article/116186585_1.html Dean, Joel (1951) Don Dayananda et al (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Drury C. Braund, S; Osborne P. and Tayles, M. (1993). A Survey of Management Accounting Practices in UK Manufacturing Companies Einhorn, Hillel J; and Robin M Fotsch, R. J. (1983). Machine Tool Justification Policies: Their Effect on Productivity and Profitability. J. Manuf Systems, 3(2): pp 169-195 Graham, John R; and Campbell R Kahneman, Daniel and Dan Lovallo (1993). “Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking.” Management Science 39:1, pp 17-31 Pike, R Stefan Yard (1999). Development of the Payback Method Int. J. Production Economics 67 (2000), pp 155-167 Woods M