Question

Write a paper about the four-steps in the capital budgeting process. The four-steps are:

1. Generating the proposal for an investment project.

2. Estimating cash flows.

3. Evaluating alternatives and selecting projects to be implemented.

4. Reviewing a projects performance after implementation and post auditing its performance.

Discuss each step.

Requirements:

500 words,

Answer 1

1. Generating the proposal for an investment project.

                                                                        Capital budgeting process starts with considering a proposal for an investment project. Business should consider the financial viability of the project by devising appropriate budgeting plan showing the estimated initial outlay of the project and annual cash outflow to support the continuity of the project. Project should not be exceeding the potential of the company. Project should be in line with financial objectives, strategy and expansion plans of the company. If the project exceeds financial potential of the company, it may turn out to be failure and the invested funds may go vein. All the requirements of the project e.g. manpower, space requirements should be feasible and should be very much within the financial strength and borrowing capacity of the company. While generating the proposal management should be clear with the exact time when the project comes into existence because Funds should not be borrowed or locked up in the project before the need arises.

2. Estimating cash flows.

                                               Estimation of both cash inflows and cash outflows is an inevitable step in capital budgeting process. While estimating initial cash outflows attention should be paid to procurement costs, all the ancillary and labour costs. Estimation of future cash inflows is more difficult than cash outflows. Cash inflows after long years require more expertise to predict. Predicting future market fluctuations can never be an easy task for the financial managers. Suitable budgeting method should be adopted to estimate the future cash inflows. All relevant factors such as market conditions, demand for the output of the project, company’s growth rate should also be considered. Depreciation costs should be added up with profit to indicate the exact cash inflows.

3. Evaluating alternatives and selecting projects to be implemented.

                                                All the viable project alternatives should be evaluated to the choose the project which generates the highest discounted cash inflows and generates the highest rate of return. The rate of return of the project should be at least equals the cost of capital of the company. There are many methods in evaluating and selecting the project. They are explained below.

1. Payback period

                                        Payback period is the simplest and easily understandable method of capital budgeting technique. Under this method, both initial cash outflows and annual cash inflows over the life of the project are estimated. Payback period is expressed in the number of years. Shorter the payback period the project is more beneficial to the company. Payback period can be calculated using the following formula.

                 Payback Period=Sum of all initial cash outflows/Sum of all expected annual cash inflows

The main disadvantage of this method is that it does not consider time value of money at all.

2. Discounted payback Period:

                              Similar to the payback period this is also expressed in number of years. Tis method is more reliable than payback period because it considers time value of money

Discounted payback period=Sum of all discounted cash outflows/Sum of all discounted cash inflows

C) Accounting Rate of Return method:

The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.

ARR= Average income/Average Investment

d)Internal Rate of return Method:

                                              Internal rate of return is the rate of return which equates the present value of cash inflows to the present value of cash outflows. A project with higher IRR should be chosen. A project which has lower IRR than cost of capital should be ignored.

e)Net Present Value Method:

                                           Net present Value can be termed as the difference between Present value of cash inflows and that of cash outflows.

Net Present Value=Sum of Discounted Cash inflows -Sum of Discounted cash outflows.

Mostly cost of capital is used to discount the cash inflows/ Outflows . Project with positive NPV is acceptable.

4. Reviewing a projects performance after implementation and post auditing

                            Once Project started its operations it is necessary that the project should be monitored and reviewed periodically. Variance analysis should be adopted to check if the project generates cash inflows as estimated. Any significant negative variance implies that the project performs poor. Such variance should be brought to the attention of the management. Steps should be taken to reduce such variances. If such variances become uncontrollable alternative projects should be considered.