Introduction
Capital budgeting is a broad subject that involves several procedures. Before making any commitment to invest or committing financial allocations to a project, there are several factors that must be put into consideration. This essay seeks to identify some of the popular decision-making processes that are used by CFOs in capital budgeting.
Capital budgeting decision
Budgeting decisions are very crucial in determining capital investments. Every Chief Financial Officer understands the importance of evaluating the Net Present Value of a project before making any financial commitment to invest. The NPV process is the most prevalent method used in capital budgeting and decision-making. When a project’s Net Present Value is positive or zero, the project is viable and worth the risk. On the other hand, if the NPV is negative, the project is not worth the threat and this is an indication of imminent financial risk.
Other decision-making methods
A part from the NPV method, there is also the Internal Rate of Return method that has also been used widely for the same purpose. The two processes give the same results especially when the same variables are used. But there is one significant difference in the measure of value for these criteria. The NPV measures the net value in dollars while the IRR gives a ratio. These are the main processes used in measuring capital investment around the globe but there are other measures that can be taken.
Prevalence of the capital budgeting decision methods
According to the survey in the report, IRR and the NPV are the leading capital budgeting methods with over 70% record of the total usage. Most CFOs have admitted that they always or mostly use the two main methods. The other three methods that have surpassed the 50 percent mark include hurdle rate, payback method and the sensitivity analysis method. The rest are below 50% and they include discounted payback, real options, and book rate of return among others.
Cost of capital
In capital budgeting, the cost of capital is a very important aspect. There are different methods of computing the cost of capital. One of the main methods used to determine the cost of capital is the Capital Asset Pricing Model, CAMP. According to the report’s survey, 73.5% of the total respondents were using this method to determine the cost of Equity Capital. The second most used method is the average stock returns.
Capital structure decisions
While making capital structure decisions, CFOs can explore several choices. The first theory suggests that organizations have an optimal Debt-Equity ratio. This is determined through a process of trading-off the gains of debt against its value. The gains of debt in this model are realized in the tax advantage presented by interest deductibility as indicated in the findings of the report. The factors that influence the decisions to issue debts include financial flexibility, credit rating, earnings, cash flow volatility, as well as interest tax savings. These are the major features that have been cited as the main factors considered by the majority of the CFOs as they make their decisions on debt.
Conclusion
This essay has discussed lengthily the financial decision making process in capital budgeting. The paper explains clearly the importance of these processes. In addition, the paper provides a conclusive summary of the prevalence in the use of these methods among financial experts.