The management should come up with a policy document that describes how the capital raised by the company will be allocated to several projects. Capital budgeting refers to the process where management decides which certain investments are worth pursuing.
The company has to choose which to use in capital budgeting. The pay back method looks at the cash flows from the project in subsequent years and compares it to the initial cost. A project may have the following cash flows for the next five years, $10,000, $12,000, $15,000, $10,000 and $8,000. The initial outlay is $40,000. The payback period of project will be calculated as follows:
The payback period is more than three years. There will still be $40,000- $37,000 which will be achieved in $3,000/$10,000 (cash flow for the third year) = 1/3 of a year. The total payback will be 3.3 years. If the company’s payback period is three years, the project will not be considered. However, if the payback period is four years, it will be considered by management.
In the net present value technique, the required rate of return is used to discount the cash flows in the subsequent years. The total discounted cash flow value is subtracted from the initial costs to get the net present value (NPV). Only those projects with positive NPV can be taken up.
In the internal rate of return method, the analyst calculates the rate of return which is the discount rate where the negative cash flows of the project are equal to the positive cash flows making the net present value to be equal to zero. The higher IRR a project has, the higher its suitability for the company.
In a review of budgeting practices of 1000 companies, it was found that companies prefer methods that consider the time value of money (Ryan and Ryan, 360). The policy should define the acceptable rate of return for the proposed investments. The acceptable rate of return should be higher than the costs of capital for the company to make profits and increase the shareholder’s wealth.
Capital has associated costs depending on the sources of capital. For loans, the company will pay interest while for equity capital it will pay dividends to the shareholders (Oblak and Helm, 39). For all projects, the internal rate of return will be compared to the acceptable rate of return for decision-making. The policy should state how often the acceptable rate of return will be reviewed. It should not be a static figure for all financial periods. It needs to take into account, rising taxes, higher risks due to economic conditions, rising costs of capital and rising opportunity costs (Shao and Shao, 45).
The policy should also specify who will be approving authorities for the various projects undertaken. The policy should also specify how the post-completion audit of the projects implemented will be carried.
It is important to compare the actual costs and cash flows of the projects with the projected costs and cash flows and analyse the reasons for the variances. The policy should be circulated to all the managers in the company and have the support of senior management for its implementation.
References
Oblak, David and Roy Helm. “Survey and Analysis of Capital Budgeting Methods Used by Multinationals.” Financial Management, 9.4(1980):37-41. Print.
Ryan, Patricia and Glen Ryan. “Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?” Journal of Business and Management, 8.4(2002):355-364. Print.
Shao, Lawrence and Alan Shao. “Risk Analysis and Capital Budgeting Techniques of U.S. Multinational Enterprises.” Managerial Finance, 22.1(1996): 41-57. Print.