Capital Budgeting Decision Process

Topics: Net present value, Capital budgeting, Investment Pages: 7 (2048 words) Published: December 1, 2012
Capital Budgeting Decision Process

1. Introduction
The maximization of shareholder wealth can be achieved through dividend policy and increasing share price of the mark value. In order to derive more profits, our company shall invest potential investments which always cover a number of years. Those investments involve substantial initial outlay at the outset and the process. The management is responsible to participate in the process of planning, analyzing, evaluating, selecting and making decisions to allocate the limited resource to those investments. This is called capital budgeting decision process. Budgeting acts as an important managerial tool in practice. It is budget for the major capital investment such as purchase of land and building, plant and machine, investing new product or market. In modern competing environment, the company shall go ahead to make those investments in order to survive and profitability. A good evidence is Apple which globally introduced iPhone and acted as a leading market position. Denzil & Antony (2007) stated that “Those decisions shall take account of the amount, timing and associated risk of expected company cash flow”. Therefore, Capital budgeting decision process is within the prospective of financial management.

2. The Aims of Financial Management
Finance management generally embraces financial decision, investment decision and dividend decision. Its aims can be varied from different company, the main aims are expanding a new market, budgeting control, maximizing profit and maximizing shareholder wealth. Keown, et all stated that “The fundamental goal of a business is o create value for the company’s owners (this is, its shareholders)”. However, the management may focus on profit maximization that will benefit him because he is the agent on behalf of the shareholder resulting in devoicing ownership and management from the company. It leads to conflict with the shareholder’s interest and may detriment the shareholder’s wealth. In order to balance those conflicts, the management shall efficiently allocate limited resource and must consider its investment strategies with its financing policies at the best interest of the shareholder. The present value of future cash flows is a better measure of the wealth of shareholder value. Cash inflows are derived from financing activities such as debt and/or equity. If those funds are used for investment decision, it implies that there will be less contribution to shareholders as a mean of dividends. Efficient and effective allocations of the funds are principle responsibility of the management. This can be achieved through making an optimal capital budgeting decision process so as to create value for shareholders.

3. Academic literature on models of the investment process The company may face many potential investments in which it has to make choices to invest. It is necessary to evaluate potential investments in order to make better decisions. Every new investment is subject to risk and uncertainty. It always takes a long period of time to report future benefit. It will severely affect the cash flow of the company. The company therefore must manage the cash flow efficiently and effectively. Some techniques are introduced to decide whether to invest potential investment. John Graham & Harvey (2000) conducted a survey of 392 CFOs found that CFOs always use Net Present Value (NPV) and Internal Rate of Return (IRR), percentage respectively is 74.9 and 75.7; Payback period (PB) is also popular 56.7 percent while Profitability Index (PI) seldom use only 11.9 percent . Alkaraan & Northcott (2006) also obtained a similar result from survey that UK manufacturing companies applied appraisal techniques. Accounting rate of return (ARR) and PB are commonly used techniques. It is important to be aware of their merits and drawbacks. ARR is an accounting ratio which is also known as...
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