Corporate Financial Management for Budgeting -myassignmenthelp

Question: Discuss about theCorporate Financial Management for Capital Budgeting. Answer: Introduction Capital budgeting decisions are also called investment decision which affects finance position related to fixed assets of the firm in long run. The capital budgeting decision is based on cost and benefits analysis and these techniques helps in evaluating the suitability of a project. The criterion is selected on basis of maximizing market value of the organization. The finance manager of an organization has to take two decisions such as short term decision and long term decision regarding their capital structure. Short term decisions are called working capital decision whereas long term decisions are called capital budgeting decision (Smit, 2007). In this context, the present report aims to demonstrate the impact of capital budgeting techniques on management decision-making of a business entity. Relation between management decisions making to capital budgeting techniques The capital budgeting decisions are based on basic three criterions that are, accept- reject decision, mutually exclusive decision and capital rationing decision. The accept reject criterion is related to independent projects which means a single project and cannot be compared with another project. The business organizations can accept or reject a project on the basis of minimum rate of return in this criterion. For example in minimum rate on investment is required by the organization is 10% and project can generate 11% rate of return then that project can be accepted. On the other hand, mutually exclusive decisions helps the management to take the decision among all the different projects in that case acceptance of one project automatically rejects all other projects on the basis of cost benefits analysis. The capital rationing decision is those decision under which capital is distributed amongst the acceptable projects because the management can distribute whole money in all the pr ojects due to limitation of resources (Moyer, McGuigan and Rao, 2014). The capital budgeting techniques are divided in two parts: Traditional techniques Modern techniques Traditional techniques: These techniques are also known as unadjusted time methods because these techniques do not consider present value of money. The acceptance or rejection of projects by management in case of this technique depends upon future cash inflows of project, if future cash inflows are more than present investments than project can be accepted otherwise it is rejected. There are three techniques under this method: Urgency Method: This technique is based on assumption that project which requires immediate action should be taken first and that cannot be postponed. For example if in a factory, a machine stops working and requires immediate repair works for Rs. 10,00,000 for continuing the production then management will spend such amount for continuation of projects without considering profitability of the project. Pay- Back period Method: Under this method that project is accepted which recovers the cost of investment as early as possible. It means this technique helps the management to select a project which recovers its cost as early because future is uncertain. Average rate of return: The management of an organization always calculate minimum rate of return on an investment that depends upon internal and external factors of the organization. If any investment proposal which can earn more than minimum rate of return that project can be accepted (Otley and Emmanuel, 2013). Modern Techniques/ Discounted cash flow techniques: These techniques consider present value of money i.e. future cash inflow is discounted in terms of present value. These techniques are: Net present value method: These techniques may be defined as difference between present value of future cash inflows and present value of cash outflows. This technique helps the management to accept or reject the project based on positive net present value i.e. present value of cash inflow is more than present value of cash outflow. The minimum rate of interest for discounted cash flows is selected. Present value index or profitability index: This technique is based on ratio of present value of cash inflow and present value of cash outflow. This is known as profitability index, if profitability index is more than one then project can be accepted otherwise it is rejected. This helps the management to decide cash inflow receivable from the project in comparison with investment in project. Internal Rate of return method: It is rate of return where NPV is zero which means present value of cash inflow is equal to present value of cash outflow. The business can decide its break even point where no profit or loss situation where inflow is equal to outflow and projected can be accepted without any loss. Discounted Pay- Back period method: Under pay back period method that project can be accepted which recovers the cost as early as possible but in this techniques future cash inflow and outflows are discounted according to the rate of interest and decision is taken. This technique helps the management early recovery of cost after considering present value of money. Terminal Value method: In this technique it is assumed that each cash inflow is reinvested immediately by an organization to generate the interest or other income. This is because reinvested cash inflow in different income bearing securities generates the compounded return to an organization which in turn provides higher return of a project (Weygandt, Kimmel and Kieso, 2009). Discounted cash flow techniques Break Even Analysis: This refers to a situation where a business realizes no profit or loss, i.e. it is level of sales where total revenue is equal to total cost. In the present competitive business environment, there is huge competition in the market where cost and selling price of the product is variable and thus management desires to achieve its breakeven point as early as possible for realizing profits. . The future is uncertain and thus management has to develop effective strategies for realizing its breakeven point and have to develop their capital structure adequately. It is always interested to decide that level of sales which can recovers at least variable cost of product. The capital budgeting techniques helps the organization with various techniques such as net present value, internal rate of return etc. According to NPV criterion the management can achieve break even points where NPV is zero. Internal rate of return techniques helps the management to accept the project where the project is ea rning at least minimum rate of return on the project (Moyer, McGuigan and Rao, 2014). Sensitivity Analysis: The various variables related to investment proposal involved different variable such as cost, market share, sales volume, selling price. The projected cash flow depends upon these variables and these variables are uncertain due to time factor and customer choices and technological development. This technique of capital budgeting force the management to identify the variables that effect the cash flow of the project and guide the management to take the right action for this variable. This technique provides the facility to the management to concentrate on the effect of change in cost, sales or other factor on the outcome of the project. The future is uncertain and management is expected to achieve desired results due to cost involved in the project. The sensitivity analysis helps in identifying how sensitive are the various estimated variables of a project. It shows how sensitive is a projects NPV or IRR for a given change in particular variables. This approach guide the management how far sales, cost and other data can affect the outcome of a project because if the cost of project decline then it will generate more cash inflows and vice versa. Under this technique, it is assumed that only one variable is changed and others are constant. If the sales of an organization increase, the inflow of a project also increases and vice- versa. In that case one variable is changed but other variable are constant. This can be done by different approaches such as optimistic approach, pessimistic approach and expected approach. Under this technique, assumption about sales are changed one time and other factors are constant and on other side sales are constant but other factors such as cost can be changed. These techniques help the management to evaluate the project according to different criterion so the management can estimate of outcome in future because of change in sales or other factors (Weygandt, Kimmel and Kieso, 2009). Scenario analysis: This is the situation where more than one variable is changed at the same time and no variable is constant. This situation is very tedious for the management where all the factors related to a project is changed simultaneously and affect the outcome of a project. If all the variables related to a project are changed in the positive direction then it is beneficial for an organisation as it will generate more cash inflows for management. However, in reverse case if all the variables are negative it provides negative results for an organisation. This evaluates the expected value of a proposed investment or business activity. The statistical mean is the highest probability event that can be expected in a certain situation. By creating various scenarios that may occur and combining them with the probability that they will incur, an analyst can better determine the value of an investment or business venture. The major drawback for these types of fixed outcome analyses are the probabilities estimated and the outcome sets bounded by the values for the extreme positive and negative events (Otley and Emmanuel, 2013). Simulation Techniques Sensitivity analysis and scenario analysis are quite useful to understand the uncertainty of the investment projects. However, these methods do not consider the interactions between variables and also, they do not reflect on the probability of the change in variables. The future is uncertain due to market choices, customer preferences, competition, technological development and market driven forces. Thus, it is essential for an organization to take effective capital budgeting decision for the objective of investment in the long run. In the situation of uncertainty, simulation techniques are more beneficial for the finance manager, because future is uncertain about cost, revenue and returns of the projects (Baker, 2011). Under this method statistical distribution such as probability distribution is allowed for each outcome of project. This technique is based on computer and reflects real time situations. This technique is known as monte-carlo simulation model. The term Monte Carlo implies that the approach involves the use of numbers drawn randomly from probability distributions. Under the simulation techniques computer generates the random numbers for each of the variables such as market share, sale price, variable cost etc. This process of randomization is attempted for lot of time to judge the expected net present value from the different factors. This process allows the management to use different calculation which is based on different factors to take possible outcome of projects under uncertainty. The management then calculates the expected net present value that is associated with standard deviation to judge the level of risk involved in project (Smit, 2007). Conclusion It can be stated from the overall discussion that all the above mentioned techniques of capital budgeting facilitates the calculation for highly complex and multi variable based investment proposal. This in turn helps the finance manager to take right decision for feasibility of a project. However, the capital budgeting techniques are not feasible in all circumstances because probability of different factors cannot be exactly measured. The capital budgeting model is also very tedious, time consuming and involve huge expenditure on the part of management. References Baker, H.K. 2011. Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. John Wiley Sons. Moyer, C., McGuigan, J. and Rao, R. 2014. Contemporary Financial Management. Cengage Learning. Otley, D. and Emmanuel, K. 2013. Readings in Accounting for Management Control. Springer. Smit, P.J. 2007. Management Principles: A Contemporary Edition for Africa. Juta and Company Ltd. Weygandt, J., Kimmel, P. and Kieso, D. 2009. Managerial Accounting: Tools for Business Decision Making. John Wiley Sons.