Capital Budgeting

LIST OF CONTENTS DECLARATION2 ACKNOWLEDGEMENT3 LIST OF CONTENTS4 INTRODUCTION TO CAPITAL BUDGETING5 CAPITAL BUDGETING PROCESS7 ORGANIZING CAPITAL BUDGETING PROCESS IN LARGE FIRMS8 CAPITAL BUDGETING DECISION RULES9 CAPITAL BUDGETING: EMERGING ISSUES AND TRENDS12 CRITIQUE13 CONCLUSION15 BIBLIOGRAPHY16 Introduction to Capital Budgeting

Indian economy as a whole has largely been insulated against the global economic slowdown, the Indian real estate sector though has been seriously affected keeping in sync with the global real estate fortunes (Economic Times, 16th June’09), nevertheless in the hotel industry there are expansions, acquisitions and exceptionally diverse structures are coming up in different markets to attain incredible growth in the business.

The union budget 2009-2010 had a lot in store for the hotel industry in specific by the abolition of the fringe benefit tax in attracting and retaining the employees. Other benefits being the development of rail, road and airports through the India Infrastructure Finance Company Ltd. and the increased budget for the commonwealth 2010 (Krupa Vohra, Travel Professional). The Indian hospitality industry of which hotels form a part is valued at $23 billion and comprise of 75% total market size.

The hotel market is expected to double by the year 2018 and about $12 billion is likely to be invested in the next two years and by 2011 there will be round 40 new international hotel brands operating in India as expressed by the Technopak Advisors, New Delhi through the Business Standard. When a business makes a capital investment it incurs cash expenditure in the expectation of future benefits, usually these benefits extend beyond 1 year in the future. An investment proposal should be judged in relation to whether or not it provides a return qual to or greater than required by the investors. The process of identifying, analyzing and selecting investment projects whose returns (cash flows) are expected beyond 1 year is called Capital Budgeting. (Horne J. C. , Wachowicz Jr J. , Bhaduri S. , 2008) Capital investments include investment in assets such as equipments, buildings, lands as well as the introduction of a new product, any up gradation or new program for research and development so in a long term the firm’s future success and profitability depends on long term decision currently made.

Capital budgeting is a very essential aspect of a firm’s financial management. If a firm makes a mistake in its capital budgeting process, it has to live with it for a long period of time and face losses. Overestimation and underestimation of the proposed investment may lead to a disaster for the company as the capital investment decisions are of non reversible in nature. Overinvestment will increase the depreciation and other costs while the company would succumb to competition due to under investment in capacity and high cost of regaining lost customer (Iyengar A. 2008) The selection of an investment project may affect the business-risk complexion of the firm which in turn may affect the rate of return required by investors, the capital budgeting process involves: ? Generating investment project proposals consistent with the firm’s strategic objectives. ?Estimating after-tax incremental operating tax cash flows for investment projects. ?Evaluating project incremental cash flows. ?Selecting projects based on a value-maximizing acceptance criterion. ?Reevaluating implemented investment projects continually and performing post audits for completed projects.

The typical case with the hotel industry is that the largest investment made is in fixed assets where in a significant proportion of fixed assets is not subject to obsolescence (Collier & Gregory, 1995; Parkinson, 1995). Fixed asset investment can be seen as the output of the capital budgeting process that involves the long-term allocation of organizational funds across departments and projects in expectation of future returns. The size of the investment in fixed assets pooled with the long-term implications of the way in which capital is rationed across an organization underline the significance of capital budgeting. Kester et al. , 1999; Lamminmaki, Guilding, & Pike, 1996; Payne, Carrington-Heath, & Gale, 1999; Pike, 1996; Trahan & Gitman, 1995). Capital Budgeting Process Capital budgeting is a comprehensive activity. There are several sequential stages in the process. For typical investment proposals of a large business, the distinct stages in the capital budgeting process are depicted in the form of a flow chart. Organizing Capital Budgeting Process in Large Firms The article develops an integrated model of capital budgeting.

The objective is to fill the traditional gap between strategic planning and the evaluation of investment proposals by integrating the analysis of all proposals by integrating the analysis of all proposals in a global scheme and rationalizing the phase that constitutes the capital budgeting process characterized by the best compromise between effectiveness and elasticity depends on a number of internal and external factors. The comparison of the model with the capital budgeting process of eight multinational firms shows that most of the multinationals have developed, either in an implicit or in an explicit way.

Precisely, the companies studied in the article seem to focus their attention on the analytical tools, while the organizational problems are often disregarded. In fact, very precise and compound procedures for the economic financial appraisal of proposals exist, but managers are becoming aware that such tools are of no use, unless they are used in a wider context of strategic planning. Only 2 companies attempt to structure the whole capital budgeting process made; nevertheless, they failed in considering some critical variables, which influence the behavior of people involved in capital budgeting activities.

Moreover, in the models some phases of the process are overemphasized, while others are nearly ignored. In particular, the phase of authorization is still considered very important, despite some related factors as the different importance of proposals. Capital Budgeting Decision Rules Six key methods are used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget: (1) Payback (2) Discounted Payback (3) Net Present Value (NPV) (4) Internal Rate of Return (IRR) (5) Modified Internal Rate of Return (MIRR) (6) Profitability Index (PI)

The author will explain how each ranking criterion is calculated, and then will evaluate how well each performs in terms of identifying those projects that will maximize the firm’s stock price. PAYBACK PERIOD The payback period, defined as the expected number of years required to recover the original investment, was the first formal method used to evaluate capital budgeting projects. DISCOUNTED PAYBACK PERIOD Some firms use a variant of the regular payback, the discounted payback period, which is similar to the regular payback period except that the expected cash flows are discounted by the project’s cost of capital.

Thus, the discounted payback period is defined as the number of years required to recover the investment from discounted net cash flows. NET PRESENT VALUE Each potential project’s value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value. This valuation requires estimating the size and timing of all of the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV.

The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV. The NPV is greatly affected by the discount rate, so selecting the proper rate – sometimes called the hurdle rate – is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment. It should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix.

INTERNAL RATE OF RETURN The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. It is the percentage return on an investment. MODIFIED INTERNAL RATE OF RETURN The discount rate that forces the present value of the terminal value to equal the present value of the costs is defined as Modified Internal Rate of Return. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment.

However, this is not the case because intermediate cash flows are almost never reinvested at the project’s IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, Modified Internal Rate of Return (MIRR) is often used. PROFITABILITY INDEX Another method used to evaluate projects is the profitability index (PI). A ratio of 1. 0 is logically the lowest acceptable measure on the index. Any value lower than 1. 0 would indicate that the project’s PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

Capital Budgeting: Emerging Issues and Trends Since the organizations have limited resources, it is not possible to invest in every opportunity which is predictable or imagined. Once a project has been identified and investigated, it is necessary to reject some projects but invest in others. In this respect, the process of capital budgeting serves to shape the future of organizations, and a variety of capital budgeting methods have been proposed to assist managers who are engaged in this important planning task. The article portraits the emerging trends and guidelines for future research and/or managerial actions.

The article presents alternative capital budgeting approaches and discusses other factors which must be taken into consideration for planning. Alternative capital budgeting approaches and factors which must be taken into consideration like, when making investment decisions on a global basis, it may be important to consider and model explicitly the risk associated with currency fluctuations (Johnson and Soenen, 1994). Similarly, organizations may want to explicitly consider aesthetics or long term effects on the physical environment (Zinkhan and Zinkhan, 1994).

Environmental effects may have large impact on a firm’s own asset or on community assets. The NVP method is not in immediate danger of being replaced by alternative approaches; but, for a variety of reasons, it is not universally accepted by financial managers (Cheng, Kite, and Radtke, 1994). The article also states the assumptions related to capital budgeting model like, financial managers frequently seem to be unaware of the objectives and demands of stakeholder groups beyond the shareholders themselves and an organization cannot achieve long-term success unless employees, customers and suppliers are satisfied.

Critique Assumption of many capital budgeting techniques is that the possibilities for future investment are immediately evident and clear. Under this assumption, strategic planning can be accomplished mechanistically and merely involves decisions regarding the allocation of resources among the alternatives. However, this assumption is often incorrect; in practice, it is creatively challenging act for corporate decision makers to define and realize the most promising possibilities for the Future.

In other words, it is more important to do the right thing than to do things right. One interpretation of this saying is that it is more important to recognize a promising (creative) option for the future than it is to select the appropriate capital budgeting method for planning purposes. That is, quality ideas may be more important than quality techniques. Though capital budgeting techniques are useful for project evaluation, organizations cannot afford to ignore the importance of generating strategic options.

In this regard, it is important to design “early warning systems” which can serve to identify environmental turning points so that corporate assets can be shifted in a timely fashion to take advantages of emerging opportunities. Another assumption of capital budgeting techniques is that financial objectives are vital and that the owners are a firm’s most important stakeholders. This assumption ignores the fact that organizations sometimes pursue objectives related to other stakeholder groups. It is not clear how to incorporate these objectives into existing capital budgeting models.

Capital budgets are too much time management and substantial delays (Fanning, 1999) and significant concerns regarding the evident ineffectiveness of traditional budgets, meanwhile, include: that typically such budgets encourage narrow-minded behavior, reinforcing departmental barriers while hindering flexibility, responsiveness and knowledge sharing; that they are seen as a rigid commitment, constraining management to out-of-date assumptions while inhibiting both management initiative and the pursuit of continuous improvement; that they strengthen the traditional vertical chain of command rather than empowering the people on the organization’s front line. Overall, it is considered that such budgeting systems often fail to give lasting improvement or generate congruent behavior.

The author suggests that what is really needed is a fundamentally new approach to such important budgeting purposes as forecasting and resource allocation, performance measurement and control management – an approach which incorporates a range of “alternative steering mechanisms” that especially promote empowerment, flexibility and knowledge sharing. Conclusion Capital Budgeting has received an increased attention in the past 10 years. Since the organizations have limited resources, it is not possible to invest in each and every opportunity which is imagined. Once a set of promising projects has been identified, it is necessary to reject some projects.

In this respect, the process of capital budgeting serves to form the outlook of organizations, and a variety of capital budgeting methods have been proposed to assist managers who are engaged in this task. Capital budgeting is a comprehensive activity. There are several sequential stages in the process. To conclude the researcher would like to say though Capital Budgets are too time consuming and encourage narrow-minded behavior, reinforcing departmental barriers while hindering flexibility, responsiveness and knowledge sharing; that they are seen as a rigid commitment, constraining management to out-of-date assumptions while inhibiting both management initiative and the pursuit of continuous improvement; that they strengthen the traditional vertical chain of command rather than empowering the people on the organization’s front line.

Capital budgeting is a very essential aspect of a firm’s financial management. If a firm makes a mistake in its capital budgeting process, it has to live with it for a long period of time and face losses. Bibliography Journals Maccarrone P. , ‘Organizing the Capital Budgeting Process in Large Firms’, Department of Economics and Production, Italy Zinkhan G. , ‘Capital Budgeting: Emerging Issues and Trends’, Campbell University Pinches G. , ‘The Use of NVP in newly Industrialized and Development Countries: a. k. a. “what have we ignored” ’ Steed E. , ‘Hotel Management company forecasting and budgeting processes: a survey based analysis’ Dayanand, D. et al, (2002), ‘Capital Budgeting: Financial Appraisal of Investment Projects’, Cambridge University Press. Fahey, L. , & King, W. (1977). ‘Environmental scanning in corporate planning. Business Horizons’ . Websites http://choo. fis. utoronto. ca/FIS/respub/ASISbulletin/ http://www. mayin. org/ajayshah/MEDIA/2008/wsj_inflation. html http://abodesindia. wordpress. com/2008/11/05/hotels-gain-as-realtors-sell-distressedassets/ http://www. studyfinance. com/lessons/capbudget/index. mv http://www. acessmylibrary. com/com2/browse_JJ_B156 http://www. hinduonnet. com/jobs/index. htm http://infochangeindia. org/index2. php? options=com_content=1=716