Introduction:
Financial manager is to choose investments with satisfactory cash flows and rates of return, therefore, Capital budgeting is a required managerial tool, thus, the efficiency of financial management is determined by whether the company has successful achieve the corporate goal. Financial management is important to the firm as it make decision based on the firm's goal which is maximize shareholder's wealth. According to Don Dayananda et al. (2002 P.4), "The efficiency of financial management is judged by the success in achieving the firm's goal."
Aims of capital budgeting decision process
Capital budgeting is one of the strategies used by management to making the decision for capital investment in order to maximize shareholder wealth. There are two different investment decisions, which is long term investment and short term investment. Long-term investment can bring the considerable impact on the firm, so the management needs the process to plan and analyze the investment. The relationship of them is shown in Figure 1.1.
According to Alaba Femi et al. (2008 P.8), "Capital budgeting is an essential managerial tool and primarily concerned with sizable investments in long-term assets." Capital budgeting concern about the long term investment on tangible and intangible assets. An effective capital budgeting can help the firm to improve the timing of asset acquisition, quality of assets purchased and installs it in an orderly manner, so it is important. Besides that, it will minimize backlogs and undelivered capital goods on a timely basis. It was a major effect on value of the firm and its shareholders wealth.
Capital budgeting process
In <Capital Budgeting Models: Theory VS. Practice - Business Forum, Wntr-Spring, 2001> had mentioned that the capital budgeting decision process has several reasons for successful in the company. Capital budgeting has continuous stages in the process which help the firm to select project from many alternatives. A simplified capital budgeting process is in Figure 2 which the following decision will be based on it.
Strategic plan
A strategic plan will be made based on the company goal to show the business that the firm is involved and the possible position in the future. Any planning that is conflicted with the firm's growth objective or profitability objective will also be segregated.
The strategic planning will guide the planning process. It provides a guideline to the following stages to keep them according to the planning. (Drury et al. 1993)
Investment opportunities
Company will research and identify underlying profitable investment opportunities and proposals that to let the remaining stages to select the suitable proposed investment project. Project proposals have to fit in with the firm's goal, mission or the long term planning.
Preliminary screening
The aim of preliminary screening is to ensure marginal and risky proposals based on primary qualitative analysis and the experience as it is not worth to spend resources to evaluate. The firm will not be able to go through the process of all potential investment proposals.
Financial appraisal, quantitative analysis, project evaluation or project analysis
Proposals which are through to the preliminary screening phase are subjected further to add value to the firm by forecasting technique, evaluation technique, risk analysis and mathematical programming technique. This stage is also called quantitative analysis, economic and financial appraisal, project evaluation or simply project analysis.
This analysis can predict the cash flows of the project, analyze the risks associated with
those cash flows, is the most important stage as the result of it will influence the project selection which affects the success or failure of the firm and the future direction.
(Brian Baldwin 1997).
Payback
The payback period is a simple measure of the time it takes to recover capital spent on an investment. It emphasizes the concern with liquidity and the need to minimize risks for the management.
If the result is less than the maximum acceptable payback period, the firm should accept the project otherwise it should be rejected.
Net present value
NPV is the most straightforward method to decide on whether the investment will generate return in excess of the minimum acceptable rate of return. NPV is the difference between the present value of future cash inflows and the initial cash outflows of investment. If a positive net present value is generate, the management should accept the project. Otherwise the management need to review its strategic plan as there may have some problem on the project.
N.P.V. = Present Value of Cash Inflows - Initial Investment
NPV < 0, reject project
NPV >0, accept project
Internal rate of return
The internal rate of return is the discount rate often used in capital budgeting that make the net present value of all cash flows equal to zero. This means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of project equal current market value. (Stefan Yard 1999).If the result is greater than the cost of capital, the firm should accept the project otherwise it should be rejected.
Profitability index
It is a measure of cost- benefit analysis to recognize the time value of money. It is the ratio of the present value of cash inflows to the initial cash outflow of the investment. The firm should accept the project if the result is more or equal to one otherwise reject the project.
Qualitative factors, judgments and get feeling
Qualitative factors have impact on the project but they are virtually impossible to evaluate accurately in monetary terms. Factors are the societal impact of an increase or decrease in employee numbers, so that may affect the value of the firm, however it may be minimize by discussion and consultation with the related parties.
The accept/reject decision
The firm will make a decision on accept or reject the investment project based on the information from the quantitative analysis and management's experience and their recommendation.
The management normally will not focus on profit, is incremental cash flow, account for the time and risk of the project as time is money. The firm wants more cash as soon as possible. Different projects got different risk. If the firm wants to have higher return, the risk must higher. The firm needs to think about whether they can face the risk or not.
The management will choose the project with satisfactory cash flows and rates of return. Normally the firm will invest the project that have a positive net present value and internal rate of return is greater than the firm's cut off rate.
Implementation
If the project is accepted, it has passed through the decision stage and must be implemented by management. During this implementation phase various divisions of the firm are likely to be involved, the procurement plan and a schedule of cash requirements for budget execution should also be included.
Facilitation, monitoring, control and review
An integral part of project implementation is the constant monitoring of project progress with a view to identifying potential bottlenecks thus allowing early intervention. It will be easier for the firm to monitor the project if it is kept as a separate part of business for example classed as its own department. The financial progress can be monitored through treasury payment and physical progress should be tied to a database of on-going projects. Cash flow should be monitored on a regular basis to avoid any deviation and take correct action when needed.
Post- implementation audit
This stage is to deal with the performance of the project that had already implemented. It looks at the project from the start to the end. The purpose is to test whether capital budgeting procedures have been fully and fairly applied to the project under review.
Auditing can identify failings in the investment progress. The central internal auditor would check the effectiveness of internal audit, internal control process, accuracy of financial records and efficiency of operations. It is to evaluate the progress of project through comparison of actual cash flows, other costs and benefit with those forecasted at the time of authorization.
This stage can provide useful feedbacks on the project for management to consider an engrained review of the firm's current strategic planning. If there are weaknesses specific related to capital budgeting systems for the firm as a whole, auditor need to report to management that the systems need to be overhauled. Therefore regular audit helps to develop better decision making.
Conclusion
The firm should pursue all projects to enhance shareholder value. Capital budgeting is focused on project which will have great impact to the future of the firm. After the nine steps process, the firm can know more about the project which is definitive to the firm's success because capital expenditures need large outlays of funds and the firm must ascertain the best way to raise and repay these fund.
