CAPITAL BUDGETING AND FINANCIAL MANAGEMENT IN INVESTMENT DECISIONS: AN ILLUSTRATIVE STUDY.

• Author: Oke, Okeniyi
• Position: Report

INTRODUCTION

Capital budgeting is the process of a firm's long-term financial management strategy. Often, capital budgeting is the listing or sources of finances for long-term investment strategies (Johannsen & Page, 1974). Additionally, capital budgeting is an investment concept that involves a commitment of current funds that can result in future desired returns (Oke 1981; Gitman, 2008). To make a business profitable, viable and sustainable, it is crucial for the firm's management to be cognizant of working capital management.

It is interesting to note that fair value options may not be explicitly considered in a traditional process, but instead, an alternate discounted cash flow (DCF) method may be used to assess a firm's long-term investment proposals. Similarly, financial analysis can have a substantial impact on the viability and sustainability of an enterprise's performance. Furthermore, it is essential for management to understand the various merits and demerits of capital budgeting process.

According to Garrison (1979), capital budgeting decisions tend to fall into two broad categories-screening decisions and preference decisions. Screening decisions are those relating to whether a proposed project meets some preset standard of acceptance. For example, a firm may have a policy of accepting cost reduction projects only if they promise a return of say 20 percent before taxes. Preference decisions by contrast, relate to selecting from among several competing courses of action. To illustrate, a firm may consider five different machines to replace an existing machine on the assembly line. The choice as to which of the machines to purchase is a preference decision (Garrison, 1979, p 523). Thus, what are the differences of capital budgeting, how does capital budgeting process work, and what must managers expect and look for in the decision-making that has limited capital?

In this study, we discuss ways of making screening decisions by evaluating several contemporary methods of capital budgeting. The various methods discussed include: (1) accrual rate of return, (2) benefit-cost ratio method, (3) payback period method, (4) net present value method (NPV), (5) internal rate of return method (IRR), and (6) sensitivity analysis. Similarly, due to environmental conditions, including contemporaneous matters of recent literature, attention is directed only to the use of selected approaches in existing finance literature.

In this study, the authors illustrate capital budgeting techniques in conducting sound project appraisals, such as planning and financing of capital outlays (Garrison, 1979; Hill et al., 1998; Lazaridis, 2004; and McGee, 1987). In particular, as an illustrative example, the operational experience from an aquacultural direct enterprise in Auburn, Alabama is explored. First, the illustrative study allows for a comparative financial analysis of the various financial techniques and/or methods using concrete specific data from the aquacultural or pond operations analyzed (Oke, 1981). Second, the decision methods also provide ample justifications in the techniques to allow for an eventual parsimonious optimization in sound financial management practices.

To the extent that emphasis on rate of return, time-value of money, and discounted value methods are in the derivations of inflows and outflows to eventually, reach at the net present value criterion. Thus, accepting a project when NPV is greater than zero or rejecting otherwise. While one cannot claim obsolete infallibility of a particular method as it will only support specific paradigm of rational decision-making. For example, the payback method is a good example of how quick the investment can be recouped. The rational approach to financial investment management is crucial because it affects the long-term viability and sustainable return on investment (ROI). Study results seem to show a clear difference in determination of the outcomes based on evidence from the distinctive methods applied. In the literature review that follows, we highlight and discuss ways of conducting the screening decisions.

BACKGROUND OF THIS STUDY

Capital budgeting decisions are integral in evaluating the performance of a business (Arya, 1998). In this brief survey, we attempt to present an overview of investment decision criteria and to bring out some of the pertinent studies for understanding capital budgeting decisions. Numerous research studies around the globe have resulted in attractive yields on capital budgeting practices (Andor et al., 2012). However, there is little research on capital budgeting techniques for small and medium-size companies and their importance to a firm's profitability (Oke, 1981). Affirmatively, researchers use different techniques on the process of capital budgeting and how important it is to raise funds for a company. Consequently, a business entity that is able to effectively develop opportunities for capital investment may overcome certain obstacles during a volatile period ty (Lazaridis, 2004).

Capital budgeting techniques

According to Rosie (2014), discounted cash flow (DCF) techniques, such as internal rate of return (IRR) and net present value (NPV) have become the dominant methods of capital budgeting techniques. The decision on capital investment is to assess the performance of a firm (Hatfield, Hill and Horvath, 1998). The importance of payback period, accounting rate of return, internal rate of return and net present value capital investment techniques are used to assess the value of a firm. Hatfield et al. (1998) emphasized that entrepreneurs surveyed in each project have on average higher stock items than those that do not. Furthermore, Hatfield et al. argued that NPV techniques did not maximize a firm's value.

Accounting rate of return

Rate of return is defined as the ratio or percentage of total profit to total investment, where the average capital investment represented the total investment. It is imperative to emphasize that this criterion was "just an approximation" as return on initial capital was below the "true return." Therefore, accounting rate of return appeared too harsh in estimating the investment's profitability. However, to most appraisers, the criterion was helpful in comparing rates at which profits were earned by similar projects or different projects.

A pond investment with rate of return that did not exceed the cost of capital was an "unprofitable concern" and should be rejected. Pond investment also enumerated the detriments of this criterion. It did not adjust for compounding values of income or consider total project magnitude. Additionally, it did not allow variability in expected yearly cash inflows, but relied totally on cost and return estimations.

Benefit-Cost Ratio Method

The benefit-cost ratio or profitability index was another procedure of investment worth used (Ray.1984, p19, Thomas & Maurice, 2011) defined as "the present value of gross benefits divided by the present value of gross costs"(Van Horne, 1980). Costs incurred and benefits received during each year of project life are stated as present values and totaled; then the benefit total is divided by the cost total. If this ratio is greater than 1:1, the project is judged feasible (Gittinger, 1972; Squire & Van De Tak, 1975). Barlowe (1978) noted if a positive ratio (a ratio of more than 1:0) was obtained, this indicated that the project proposal was economically feasible. Hence, Barlowe recommended the procedure for economic analysis.

Payback Period

The payback...