the proposed capital investment project and a short discussion of the gap between the theory and practice of capital budgeting

Capital Investment 5

Sources of Finance for the Proposed CI Project and the Gap between the Theory and Practice of Capital Budgeting

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Introduction Comment by Ufuk Misirlioglu: No need along introduction, and add a very limited contribution.

Capital budgeting is one of the key processes businesses use to determine the potential of projects succeeding or failing to recuperate the initial financial investments. The process is very critical when large companies want to expand or introduce huge assets, which probably require colossal amounts of first cash investment as well as maintenance. These investments and projects can range from constructing massive new production plants to other long-term schemes. In such instances, business capital investment managers often spend a significant amount of time assessing the new project’s prospective lifetime success, including the cash outflows and inflows. This investment appraisal process is important in evaluating whether the potential outcomes or revenues generated can meet the target benchmark.

After achieving a successful capital budgeting plan, it is critical that a firm evaluates its prospective financial sources to fund the proposed projects. For example, based on its financial position, the projected amount of investment capital, and the repayment duration, an organization can either opt for a bank loan or sells its equity to other potential investors. That being said, Foster Construction Ltd needs to assess a wide range of possible financiers to support the purchase of the new ALII. This paper, therefore, mainly discusses some of these capital financing proposals the company can explore, with the last section detailing the existing gap between theory and practice of capital budgeting.

Discussion

A. Sources of Finance for the Proposed CI Project

Foster is a reputable company and boasts of a sizeable annual revenue-meaning that the firm cannot struggle to pay its debts. We truly have quite a range of options that can assist us to fund the new ALII capital project as a private firm. The following are some of the two most viable financial alternatives for the organization:

Firstly, I propose we obtain a short-term loan, probably payable within four years, from a renowned financial institution or commercial bank. I strongly believe a short-term loan can assist the Foster Construction Ltd to buy and maintain the modern ALII crane and restore the old one for the next four years. However, there are critical factors that must be considered before identifying the right financier and the amount we can apply. Current and projected inflation rates in the country will definitely play a central role. We must also consider the interest rates offered by each particular organization to determine the lowest repayable amount within the four years. Comment by Ufuk Misirlioglu: Mismatch. Comment by Ufuk Misirlioglu: This is not a short-term. Comment by Ufuk Misirlioglu: What does it mean exactly?

Obtaining a loan, which is a form of debt financing, is the most preferred option since the company will not give up its business ownership in terms of equity for funding. Another main benefit is that the loan the company will borrow is potentially subject to tax deductions because it is classified as a business expense. Thus, the interest and principal payment may all be subtracted from the firm’s income taxes. However, some of the drawbacks associated with debt financing range from the potential of facing high-interest rates, a possibility of failing to meet the deadline agreed upon by the lender perhaps if the investment does not succeed, and the chances of the loan affecting the company’s credit rating. Considering our annual revenues and financial performance, I believe Foster Construction Ltd can never fail to repay the loan in a span of four years (Gower, 2012, p. 44). Comment by Ufuk Misirlioglu: Why? Comment by Ufuk Misirlioglu: Evidence? Comment by Ufuk Misirlioglu: What is it for?

Secondly, if the owners opt not to obtain a loan perhaps because of the significantly higher interest rates, I believe issuing the company’s equity shares to private investors or the public can assist raise the funds. Without question, FCL is a large and renowned private company. I truly think the organization can decide to go big and global in January by issuing an initial public offer (IPO) for the public to purchase some of its shares. Besides giving Foster the required financial muscle to expand and purchase modern equipment, issuing an IPO is a critical marketing plan that can familiarize the firm with potential customers. On the downside, enlisting the firm as an IPO can result in equity dilution and loss of management control (Baker, Filbeck, & Kiymaz, 2015, p. 220). Comment by Ufuk Misirlioglu: ? Comment by Ufuk Misirlioglu: ? Comment by Ufuk Misirlioglu: ?

B. The Gap between Theory and Practice of Capital Budgeting

Today, there is no doubt that there exists a huge gap between the theoretical aspect and the practical implementation of capital budgeting concepts and techniques. Theoretically, capital budgeting methods are identified as crucial techniques firms can use to authorize capital spending, especially on long-term projects. As AlKulaib, Al-Jassar, & Al-Saad (2016, p. 1273) note, capital budgeting experts must apply both qualitative and quantitative methods to appraise the viability of their projects. Most essentially, capital investment decision-making implies that managers should establish the expected value that a project is expected to create effective capital budgeting requires the use of exquisite and all-inclusive techniques, including the discounted payback periods (DPP), the payback periods (PP), the net present value (NPV), the modified rate of return (MIRR), and the internal rate of return (IRR). Therefore, a project is only approved or termed viable if it exceeds all these hurdles or requirements. But, as AlKulaib, Al-Jassar, & Al-Saad (2016, p. 1273) note, the theoretical requirement of capital budgeting is never reflected in practice. For example, most companies mistakenly use cash outflows and inflows as opposed to net income, while others occasionally compute cash flow using amortization and depreciation plus net income. Comment by Ufuk Misirlioglu: What does it mean exactly? Comment by Ufuk Misirlioglu: What are they? Comment by Ufuk Misirlioglu: Theory or practice? Comment by Ufuk Misirlioglu: ? Comment by Ufuk Misirlioglu: What are they? And why? Comment by Ufuk Misirlioglu: Why are they important for capital budgeting?

Conclusion Comment by Ufuk Misirlioglu: ?

In summary, it can be deduced that capital budgeting is very fundamental to the implementation of capital investments, playing a central role in the identification of viable long-term projects. Drawing from this benefit, Foster Construction Ltd cannot negate the impact of capital budgeting in assessing the potential financial impact of purchasing a modern ALII crane. However, from the discussion, it is clear that getting the right funding source for any organization is a major problem, with companies often forced to make several crucial considerations. For that matter, Foster Construction Ltd has two main sources of capital financing for the purchase of ALII. The first one is applying for a loan from a financial institution like a bank. The second involves issuing the firm’s equity shares to private investors or the public.

References

1. AlKulaib, Y. A., Al-Jassar, S. A., & Al-Saad, K., 2016. Theory and Practice in Capital Budgeting: Evidence from Kuwait. The Journal of Applied Business Research, 32(4), pp. 1273-1886.

2. Arnold, G. and D. Hatzopoulos, P. (2000). The Theory-Practice Gap in CapitalBudgeting: Evidence from theUnited Kingdom Comment by Ufuk Misirlioglu: Is it used in the main text?

3. Baker, K., Filbeck, G., & Kiymaz, H., 2015. Private Equity: Opportunities and Risks. Oxford: Oxford University Press.

4.  Chittenden, F. and Derregia, M. (2015). Uncertainty, irreversibility and the use of ‘rules of thumb’ in capital budgeting Comment by Ufuk Misirlioglu: Not in the text?

5. Gilbert, E. 1999. An Investigation into Uncertainty and the Capital Investment Decisions of Manufacturing Firms in South Africa. University of Cambridge: unpublished PhD thesis.

6. Gilbert, E. 2003. Do managers of South African manufacturing firms make optimal capital investment decisions? South African Journal of Business Management. Comment by Ufuk Misirlioglu: No, it was published in 2005.

7. Morrison, R., 2012. The Principle of Project Finance. Gower Publishing Ltd.