Capital Budgeting Decisions

Running head: Capital Budgeting Decisions

Capital Budgeting Decisions

Debra Williams

Wayland Baptist University

Dr. Ralph Palumbo

Managerial Accounting

ACCT 5301

Deciding on a New Project is Critical

Most human beings at some point in their life time make long term investments, such as a vehicle or house. In this paper, though, I will be talking about the kind of long term investments all types of organizations make. Organizations during their life time make decisions on investing in equipment, expanding their organization, or acquiring a new facility which is what you call a long term investment. If an organization decides to invest in new equipment, they will want to know if it will be wise to lease or purchase the new equipment. It comes down to will this new equipment maximize the investor's investment. On any decision the organization decides upon, they know that their main concern is to maximize the investor(s) investment. You do have to keep in mine thought that although the company's main concern is to maximize the investor(s) investment, an organization also want to keep other stakeholders happy, such as customers and clients. If a product does not meet the customer's expectations, they will go elsewhere. An organization will want to know if the new equipment will produce the same quality of products as the one being replaced.

If investors are going to invest in a project, they are definitely going to want to know what the return on their investment is going to be in the future.

The first thing capital budgeting requires is deciding on which project to take on what method to use. A careful decision will have to be chosen to determine which project will be in the best interest of company and the investors. We will have to decide what the minimum required rate of return for the project. Capital budgeting requires a lot of decisions.

The organization will have to keep in mind on when the project is to start. Once all the decisions have been decided, the proposal will be presented to the investor(s) on which project they see as profitable or not.

Investor(s) may think it may be a project worth investing in, yet want to be refined a little more before giving the final ok to invest in the project. Investors want to know before investing in a long term venture. Investors are always looking to maximize their dollar.

As shown below, Schnabel (2010) gives a few examples of how timing is everything when starting a new project:

The entrepreneur has the option of postponing the startup with an eye to enhancing its profitability in addition to either rejecting or undertaking the venture outright. This particular scenario is analyzed here to explore the impact of timing considerations on the interest rate sensitivity of investment expenditures. Another decision scenario that fits well the model elaborated here is that of a power utility company planning the construction of a hydroelectric dam.

Postponing construction allows design modifications and improvements, which redound to the increased profitability of the megaproject but also delay the realization of net present value (NPV). Yet another setting where these considerations are critical is pharmaceutical R&D, where delaying the launch of a new medicine may be considered in the hopes of enhancing its effectiveness and, ultimately, its profitability. The postponement option, as modeled here, is sufficiently generic to allow application to a wide gamut of capital budgeting situations. (p. 53)

Once the majority of nonfinancial plans are agreed upon, the organization will then want to focus on the financial plans. The financial plans include the cost of the equipment, the organization's budget, cash flows, and net present value (NPV). Investing in a long term investment will require a large amount of money. So, when an investor invests in a long term investment they will want to know how long it will take for the investment will be paid off and if there will be a profit. Investor's wants some kind of return for borrowing their money over a long term. So, investors will want to know what will be the company's estimated cash flow.

Methods that Measures A Company's Cash Flow

With Net Present Value a company will want to decide what interest rate to use. One of the processes of deciding o a project is forecasting future cash flows. You can layout the best plans on forecasting the flow of cash and still have the possibility of an error. Investing in any kind of venture is a risk.

MS Excel is a help tool when deciding what method to use. One method to use in capital budgeting is the discounted cash flow (DCF). Mian and Velez-Pareja (2007) states that:

A large percentage of companies use the discounted cash flow (DCF) approach as the primary technique for investment/project evaluation and the capital budgeting process. This approach requires forecasting the detailed cash flow of the project under evaluation and then discounting the resulting cash flow to the present value (Net Present Value-NPV) using an appropriate discount rate. (p. 1)

Although there are a lot of companies that use the discounted cash flow which is the Weighted Average Cost of Capital it has many flaws. According to