Capital Budgeting
Capital Budgeting is a management tool used in investments appraisal. The management of an organization needs to determine the long term investments to be undertaken by an organization. The duty lies on the financial manager to determine the investment project with satisfactory rate of return and cash flows. The manager should evaluate, compare and select the best investment project (Gil, 2005).
Budgeting decisions are important to an organization for they assist in allocation of resources to the best investment decisions that will maximize the returns. Capital in every organization is scarce hence budgeting helps to control funds in the organizations. The budgeting decisions helps an organization maximize its profits by investment in the best investment project which have consistent cash flows and high returns. Long term investments are irreversible in nature as such budgeting assist an investor in making correct investment decisions. A company would incur huge losses in case wrong decisions are made. Budgeting involves a given time period this helps in analyzing projects in terms of future cash flow and accounting for payments in the present time period.
Purpose of Categorizing Projects
Capital budgeting assists in the decision making process, as such projects are appraised accordingly. The projects that have high returns should be encouraged while the projects that have fewer returns should be discouraged. The classification of projects assists the investors or manager in making decisions without considerations that may led to confusion.
Financial Analysis in Capital Budgeting Decisions
Financial analysis involves the assessment of a business in terms of viability, profitability and stability. Financial analysis should form a major part of the capital budgeting decisions. This is because the analysis will provide the decision maker with an appraisal of the projects viability and the profitability expected from the project. A project might be profitable but not sustainable in the future.
Steps of Capital Budgeting Analysis
The steps in capital budgeting involves estimation of the projects cash flows over a given period of time. Secondly, an assessment of the riskiness of the cash flows is done. Thirdly, an appropriate discount rate is determined. The discount rate is the return expected from the cash flows or the cost of capital. Calculation of the present values using the discount rate is the fourth step. Finally, a decision is made on whether to undertake or reject the project (Brown, 2001).
Net Present Value and Internal Rate of Return
The net present value is present value of cash flows adjusted for the initial cost while internal rate of return is the discount rate when the present value of estimated cash flows is equal to the initial investment. The IRR method is more popular in the business environment than then NPV approach. This is because, in the case of NPV, the discount rate is given thus calculations will be based on a predetermined discount rate; if the rate is misleading, the decisions made will be misleading. However, in the case of IRR the rate of return is determined given the projects cash flows; this gives a correct rate of return. The rate of returns sometimes gives two rates of return or a very large rate. In such a case, further analysis should be carried out.
Importance of a Post-Audit in Investments Decisions
A post-audit is important in investment decisions for it evaluates whether the capital spending authorized have been exceeded. The audit monitors the expected benefits from the investment are being obtained. It ensures that the project is implemented in time, and no delays are experience.
References
Gil, L. A. M. (2005). Fuzzy logic in financial analysis. Berlin: Springer.
Brown, K. S. (2001). Guide to long term care financial management. New York: John Wiley.
