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Running head: CAPITAL BUDGETING 1

CAPITAL BUDGETING 4

Capital budgeting is the process and practice of valuation of the assets and projects of a firm or a company. Real assets include the buildings, machinery, a developed brand or new product, new machinery to replace old and outdated machinery and projects that are at the center of a firm’s R$D activities. Resources of the firm are always allocated towards financing and procuring these assets and the assets are intended and meant to ensure that the firm increases in terms of its asset and total value. The shareholder value should always be at the heart of a firm and it should be given top priority in a firm and this requires that a firm capitalizes on its capital which is always a scarce resource (Nicholas, 1984).

Assets in a firm are aimed at and towards ensuring that the future benefits and profits increase. Assets are a form of investments that are aimed at ensuring that the long term goals of a firm are achieved. The assets are a way of increasing cash flow into the firm and their acquisition requires that intensive capital investments be made.

An analysis of capital budgeting is usually done by firms and organizations. The analysis is aimed at ensuring that the assets that a company or an organization invests in are repayable or refundable within a given time period. The amount that an asset cost must be repayable, and other than its repayment, the repayment must have or generate profits from the very assets (Steven, 2005).

A firm usually has many different projects to invest its capital and resources towards in a given it is time. The returns from different projects in a firm however differ in that there are those that have higher returns on investment. A firm should always choose or go for those projects and subsequent procurement of assets that are likely and expected to have highest returns on investment the shareholder value in a firm is increased. However, capital is always a limitation towards financing projects in a firm. This call for the application of techniques of capital budgeting techniques in an attempt to establish which projects are most likely to generate greater income (Nicholas, 1984).

In a firm, capital budgeting is calculated through different techniques. The methods of conducting an analysis on capital budget include; net present value, payback period, through the discounted cash flow and through the internal rate of return. The efficiency of investment in a project n a firm is measured through the method of internal rate of returns. Usually, a net present value of zero in a firms capital budgeting is given through the Internal Rate of Return. If the net present value of a project indicates a positive, then the project should be accepted, but when it is negative, the project should be rejected (Steven, 2005). Rejection when the net present value is negative should be done because it means or is an indication that the benefits that are to be accrued from a project are not likely to be adequate enough to cover for the investment that is to be made in the given project (Nicholas, 1984).

Importance of capital budgeting

The greatest importance of capital budgeting is that the profitability of the firm is always at stake and more importantly, a firm invests and spends a large amount of its capital. The success of a firm is highly determined by how well it is able to use and manage its capital in its development projects and the kind of assets a firm procures. Capital in a firm should be spent in the most appropriate manner and capital budgeting is done in order to ensure that a firms capital is spent in an effective manner.

Capital budgeting is also important because it is a determinant of long term investment decisions made in a firm. Long term investment decisions are not easily reversed and their reversal is expected to have tough consequences to the firm. Reversing a long term decision would be risky since it would end up costing a firm much of its resources that were invested in the implementation and delegation of the long term investment. This would have long lived consequences to the firm in terms of its finances and the manner which business is to be handled and conducted in future years in the firm (Varshney, 2010).

Capital investment in different projects is f great importance in enhancing and increasing capital gains and benefits from the projects. Investment decisions in firms being made after capital budgeting ensures that he risk of the project being invested in or the asset to be procured is reduced significantly. Having an analysis of capital budgeting being done in advance, the rate of returns on investment from the projects and the assets is increased (Steven, 2005).

Long term investment decisions require capital budgeting to be conducted because these decisions have great risks and levels of uncertainty attached to them compared to short term decisions in a firm. Capital budgeting is a way of reducing term the risks involved in making a long term investment decision (Varshney, 2010).

Capital budgeting in a firm is influenced by many different factors. The projects that are to be financed are influenced by the following factors;

The amount of capital available in a firm is one o the greatest factors affecting capital budgeting. Capital is always a scarce resource and its effective use and management in the most appropriate investment projects would be to the advantage of the firm (Steven, 2005).

The capital structure of a firm is another determinant factor of capital budgeting. The capital structure of a firm determines the manner which a firm or an organization funds for the procurement of its assets and finances it’s different research and development projects. The capital structure of a firm influences capital budgeting in that it where investment in an asset or a project is to be made there has to be established the source of financing whether it is to be financed from a single source or a variety of sources (Steven, 2005).

The economic value of a project or an asset is a determinant factor of capital budgeting. Different projects and assets to be procured in a firm have different economic values. Those projects that have a higher economic value are prioritized in terms of capital budgeting.

Immediate need of a project or an asset also influences capital budgeting. In capital budgeting, those projects with a greater need and with greater urgency call for them to be budgeted for first. The level of urgency or need of a project could however be misleading leading to investment in assets and projects that have a low economic value and returns though and have a greater level of urgency (Varshney, 2010).

References

Nicholas, S. (1984). Corporate financing and investment decisions. Journal of Financial Economics , 187–221.

Steven, M. (2005). Economics: Principles in action. Upper Saddle River: New Jersey.

Varshney, R. (2010). Manegerial Economics. Daryaganj: Sultan Chand & Sons.