Issues in capital budgeting
Capital budgeting is the total process of generating, evaluating, selecting, and following up on capital expenditures. A capital budget is a list of planned investment projects usually prepared annually. Although capital assets comprise a smaller percentage of a firms total assets than do current assets, capital assets are long-term. Therefore, a firm that makes a mistake in its capital budgeting process has to live with that mistake for a long period of time. Capital budgeting has two parts. ... The second is allocating available capital amongst projects and costs to determine feasibility. There are many issues to consider in a capital budgeting system. Among them are Timing, Tax Issues, Cash Flows, Exit Strategies, Beta Testing, Customer Issues, International Issues, Competitor Issues, and Technological Issues. In addition, there are three major methods used in capital budgeting: Net Present Value (NPV), Payback, and Internal Rate of Return (IRR). These methods assess the value of the capital project. ... Tax Issues Companies should estimate cash flows in after-tax terms for capital budgeting purposes. ... Also, the total cash flows should not be used because incremental cash flows are significant in capital budgeting. There are two major types of cash flows used in capital budgeting: investment and operating cash flows. ... Both take into account the change in working capital, which companies should verify for accuracy in terms of amount and timing. ... Once these are calculated you can apply any of the capital budgeting methods to evaluate the project. ... Cash flow budgeting is a good place to begin to predict net cash flows. ... NPV Net Present Value is a critical method of capital budgeting a company needs to utilize when considering an investment. ... Typically, the company uses the cost of capital as the discount rate. If the NPV is positive, then a company should approve the project because it shows that the company is making more money on the investment than it is spending on its cost of capital. ... In addition, the choice of a standard payback period is arbitrary, unlike the NPV, where the firm can go to the capital markets to get the discount rate. ... Generally, if the rate of return exceeds the firm’s cost of capital, then a company would accept the project. If the rate of return is less than the cost of capital, then the project should be rejected. ... Here are a few issues that a company considering beta testing should prepare for: (1) Consider the purpose of the beta test – it is important to preset the goals of the test and formulate the testing procedure in order to best achieve those goals. ... Customer Issues: When capital budgeting, customers should be considered when making any major decisions. ... The company should make sure that their customers would not be adversely affected by any major capital investments. ... International Issues: When capital budgeting, international affects have to be considered as well; such as the foreign exchange rates and the social, economic, and political situations of the countries the company is present in. ... Social, economic, and political issues of these countries are important as well. ... Competitor Issues: A company needs to make sure that their product has a true competitive edge by providing distinctive attributes and value to the customer. ... Technological Issues: An overall look at the technological evolution can show a company a great deal when assessing a capital project. ... Capital projects should be in line with the corporate strategy or vision and should welcome innovative ideas. ... It is imperative to examine the downstream effects of the budgeting decision to seek out all the hidden costs. ... In conclusion, the three major methods in capital budgeting are always helpful to a company. However, there are other external issues as mentioned that also need to be considered. When deciding whether to accept or reject a capital project, a company can calculate their cost of capital on the project to determine the minimum return on the investment. ... If the project is going to be global, international issues are important to the initial planning stages.