This report is about the capital budgeting decision process. Financial management is how to contribute an optimal capital budgeting decision process. One company is success or failure that may be affected by good or bad capital budgeting decision. Because the financial management can make a smart decision that will great effect of shareholder's wealth. Thus, financial management should manner efficiently so as to maximize shareholders wealth.
Introduction
"In recent years, the words "maximizing shareholder value" have become a battle cry for managers and directors." [1] Hence, financial managers play an important role within the company. The financial management is planning and supervising a company's long-term investments. More and more external factors are impacting the financial manager's investment decision, such as global issues, fluctuating exchange rates, inflation, and so on. As a result, financial management must contribute to an optimal capital budgeting decision process in order to add value for shareholders.
The aims of financial management
The primary aims of financial management is seek maximize wealth for shareholder, e.g. increase share price, seek growth and periodic dividend payout. If shareholders are dissatisfied with financial management manage the company, they may sell their shares and invest another company, thus it will put down the share price. "As a result, management must focus on creating value for shareholders and pursue product-market strategies." [2] Therefore, the management should pursue more the future returns for shareholders.
Whenever the company invest long term project, it should not accept the high level of risk, because so long as one project failure, it may affect the whole company's going concern problem. "The Financial management must consider the timing and risk as they make important financial decisions. In this way, financial management can make decisions that will contribute to increasing shareholder wealth." [3]
"Financial managers should not use profits as a criterion for making decisions because profits may not be serving the best interests of the shareholders." [4] Shareholder may not like higher short-term profits, but lower long term profits. Because a company may be in order to increase profits to reduce each year's dividends. Financial management should contribute optimum capital budgeting decision process to create shareholder value. Capital budgeting is the entire process of analyze and decide which ones of the proposals to invest. It concerned with investment in the long-term assets. It includes tangible and intangible items such as property, research and development (R&D) for new technology, and so on. Due to the long term investment will seriously impact on the company's future cash flows. Thus, "Capital budgeting decisions have a long term impact on the firm's performance and they are critical to the firm's success or failure." [5] If the company invests too much, it may excess capacity. In the contrary, if invest not enough, it may not sufficient to earn much more return.
Capital Budgeting Decision Process
Capital budgeting is the process of identify, analyze and select potential investments which ones to accept. We invest in fixed assets should be consistent with the goal. As a result, a good capital budgeting decisions can maximize the shareholders' wealth. The overriding aims of any proposal is to make the best contribution and consistent with the company goals.
Figure 1 the capital budgeting process.
Strategic planning
Firstly, the company must have a strategic plan and clearly objective of the investment. Also, financial management needs determination of the budget of investment such as how much is to invest in each project? These proposals must fulfill the aims of the company.
Identification of investment opportunities
Then, the financial management will identify of investment opportunities that are important step in the capital budgeting process. In a company, there may be many potential investment proposals we can choose, but in virtue of the company's resources is limit, so the financial management must identify potential optimal proposals. The preliminary screening may base on feeling and experience to determine whether worth investment. Subsequently, it will be subject to more detailed analysis.
Appraisal potential projects
After preliminary screening, financial management should evaluate these projects whether or not add value to the company. It must evaluate a proposed project to predict the expected return from the project, because forecast future cash flows are important part of budgeting process. The firm invests cash now in the hope of receive more and more returns in future. Also, the other important step is evaluated the risk and return to determine accept or reject of these projects. Financial management must choose the most suitable project from a number of different kinds of proposals in its budgeting process. "Once the projects have been identified capital budgeting criteria are applied to analyze the cash flow from each project, and the project is determined to be either acceptable or unacceptable." [6]
Project Authorization and implementation
Following appraisal, the proposal will determined to approve, the management authorization until it is accept and reject. "The authorization of major projects is usually a formal endorsement of commitments already given." [7]
Monitoring
Post-implementation audit is the monitoring of the process to identify the errors in the project. It helps to better decision making and forecasting preciseness.
Key stage of the decision process
A well capital decision process, the financial management not only forecasting how much future cash inflows, but also in consider the uncertainly factors. In evaluating capital decision making, it should concerned with the risk, the expected return sometimes may not be achieved. If the proposed project's risk is higher than the expected returns, the investment proposals should think over whether made.
"A literature survey shows that discounted cash flow techniques like Net Present Value (NPV), Internal rate of return (IRR) and payback are very popular among corporations and advisors. When used correctly, these techniques can help financial director allocate scarce resources wisely." [8] In NPV, when a project has positive, so the company should accept, if negative, it should be reject, which means that they will implement the project now or never to implementation. In fact, when the company investment in some project. It can get the positive NPV, but it may need to 50 years above. In first 49 years, the NPV occur the negative NPV. Afterward 50 years the company can earn much money, but the project has been rejected owing to calculate the NPV occur negative at the beginning. Therefore, the company may lose create more wealth opportunities.
Due to traditional investment analytical methods are difficult to predict future return. These methods also can only be measureable in quantitative financial factor. Therefore, new methods are being arisen. As a result, we can through modern technique to comprehensive analysis the optimum projects. A multiattribute decision model (MADM) and Real option. MADM introduce to overcome the limitation of traditional methods. "It considers quantitative and non-quantitative financial factors in evaluating a technology investment such as company image. Thus, it is able to evaluate the investment's impact even if some of the determining factors cannot be estimated in dollars." [9] Furthermore, real option also can overcome the NPV shortage, it can delay an investment decision until obtain more information to reduce uncertainly factors. As a result, the finance function can best contribute to that stage in order to create shareholder value.
The best practice design for the decision process
Figure2 the best practice design for the decision process
A well decision process can make the best contribution to company goals. Therefore, there should be comprised of essential involving strategic planning, screening, project evaluation and authorization, monitoring and control. The above essential must cannot be neglected. However, the external factors increasing constantly, so the financial management should consider decision process even more extensively.
In project evaluation, financial management must consider about quantitative analysis that test to determine whether accept. Afterwards, it will think over qualitative factors, such as new technology proposals are particularly difficult to evaluate, because it may involves many qualitative factors.
In reality, financial management is difficult to forecast a whole investment project outcome ultimately. Traditional techniques are help to forecast of future cash flows, but it cannot predict long-term investment cash flows accurately. However, post-implementation audit is not only evaluation past decisions, but also improve of current investment decision process. It may involve two main purposes of improve forecasts and operations. It will compare the actual results with previous predict. Therefore, it can help the management review of the company past decisions and current strategic plan. Post audit is an important element in a good capital decision process.
Summary
The financial management use limited resources to maximize shareholder wealth. Thus financial management must efficient manner to achieve the company objective. The evaluation of projects are critical important in the capital budgeting process. It can help company to choose the right answer. Although, the financial management can help company manage the company efficiently. However, the market has many uncertainly factors in future that it cannot predict all the time. The right answer is the market determine eventually.
Recommendation
In fact, the company's resources are limited. Capital budgeting decision process to become very important stage. Therefore, the financial management should consider more different aspect of decision process so as to make an optimum decision. In a strategy aspect, decision process should consider the whole-company perspective. It shall not just taking into account of one division, as one of failure project may affect the whole company keep going. Besides, in terms of non-quantitative financial factors are difficult to measure in dollars and intangible benefits are unable to calculation, for instance, new technology can increase more cash inflow? For this reason, the company should not only use traditional technique, it should also use modern technique to appraisal the optimum projects so as to maximize wealth for shareholders.
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Bibliography
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