Analytics in the Real World
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project_yousif.docxBusiness Analytics in Capital Budgeting.
Capital budgeting is a planning procedure that business institutions use to decide which of the available investment opportunities will generate enough income to achieve the highest return on capital. Capital budgeting is important for various reasons. First, investments chosen have to be worth purchasing since most are long-term ventures. The organisation also needs to forecast revenue over the period when the asset will be in use. To make this decision wisely, the firm needs to have an objective. For most businesses, their main driving force is profit maximization. There are several tools that can be used in capital budgeting. These include payback period, net present value and internal rate of return (Gad, 2015)
Microsoft Excel’s Solver tool is an efficient tool for capital budgeting. Companies use it to select the best projects to undertake using a limited capital budget. It is suited to make several decisions in the best possible manner while satisfying a number of predetermined logical constraints (Fylstra, Lasdon, Watson & Warren, 1998). In this case, the Microsoft Excel add-on is used to determine projects that will produce the maximum net present value.
To begin the procedure, one needs to type the names of all projects into the rows. It is advisable to start some few rows below, say row six in order to leave space on top for other additional computations. The first column is titled “Decision”. This is where the final output will appear, the determinant of whether to consider the project or not. The user creates a worksheet with a list of projects on the rows. The first column contains the Net Present Value for each project. The next set of columns contains the amount of capital that will to cater for the project for the years under investment (Fylstra, Lasdon, Watson & Warren, 1998). The user also indicates the total amount of capital available for utilisation. The next set of columns contains the amount of labour to be used and the total amount available.
The procedure applies the technique of binary changing sells to make selection (Winston, 2015). This normally assigns the numbers 0 or 1 to cells. If a project’s outcome is 0, the organisation rejects it. If the binary changing cell equals 1, the organisation undertakes to do the project. To set up the solver to perform such an operation, one needs to select the changing cells they want by including a limit. This is done by selecting the cells under consideration then choosing “bin” from the Add Constraint Dialog box.
After constructing the worksheet, the user is set to begin the project selection. He/she will need to select the target cell, changing cells and constraints to work with. The target cell contains Net Present Value for each of the projects. The changing cells are those below the first blank column that was named “Decision”. They will contain the binary values 1 or 0. For the constraint, one has to ensure that the capital and labour used in each year of operation is equal to or less than the amount of capital and labour available (Fylstra, Lasdon, Watson & Warren, 1998). The user will achieve this by typing the constraint indicating that the cells containing total for capital and labour required is less than or equal to the cells containing the total amount available, for instance F3:K3<=F5:J5.
The aim of the company is to maximize the Net Present Value of selected projects. The constraint mentioned earlier on is what makes the changing cells binary. If the constraint is met, The binary number is automatically 1. If total of capital or labour to be used is less than what is available, the binary becomes 0. To add the constraint, one needs to click Add in the Solver Parameters dialog box and then select Bin. A dialogue box for Add Constraint appears and then the user sets up the binary changing cells that will display the binary numbers after clicking on solve. The maximum NPV is the total NPV for the approved projects.
Excel Solver has brought a revolution in determining the capital budget. It is an efficient method that takes advantage of a computer’s fast processing capability to quickly analyse the different provisions for various projects to come up with the best. It saves on time, as one only needs to know basic Ms Excel skills like formulae. It also reduces paperwork and gives a lasting solution to former manual computation methods. Solver ensures accuracy since it computes based exactly on the constraint that one enters. In addition to that, the Net present value method used accounts for the time value of money. This is considerably reliable since it discounts future cashflows.
The Solver method however has some drawbacks. The method operates on the computer “Gabbage in Gabbage out” slogan. If one enters the constraint inaccurately, keys any formula, or values wrong, he or she is bound to get the wrong output. This could be hazardous to a firm, as a wrong decision in creating a portfolio would mean encountering losses in future. It is even more risky in this case as Excel involves computing a series of values at a go. Another drawback for this method is that the Net Present Values are estimated future cash flows of the portfolios (Jan, 2013). These may not be close to the real results. Thus, the projects selected could be based on false value right from the start.
Current methods used to make capital budgeting decisions are relatively efficient though the investment industry could still use better and more accurate decisions. In future, researchers should come up with techniques that accounts for factors such as inflation. Inflation is the drop of in currency value of a country which causes increase in prices of commodities over time. It affects investment appraisal in several ways. It leads to changes in values of expenditure and future cash flows. Despite the fact, it is not accounted for in appraisal decisions in most firms.
They assume that I the event of inflation, both net revenues and costs of the project will rise proportionately hence it will have no impact (Bora, 2013). However, this is untrue. Inflation affects cashflows and discount rate. In reality, selling price of products and costs of production respond differently to inflation. Managers should make inflation adjustments consistently. Output prices should be more than the expected inflation rate to prevent losses. Otherwise, it is possible to forego a profitable investment plan. Future research should therefore consider inflation adjustments for accuracy.
In conclusion, every firm wants a capital budget that will make use of minimal resources while maximizing costs. This calls for capital budgeting to determine which investment plans will be most efficient. The Excel Solver is an efficient tool of determining the most viable projects. It allows the user to set a budget constraint that assigns binary values to each project. Finally, he/she is able to select the portfolio that will be most profitable. It is a quick way to perform capital budgeting. Currently most methods used in investment appraisal do not account for the impact of inflation, yet it affects investments. Future researchers should generate tools that account for inflation to obtain more accurate results.
References
Bora, B. (2013). Inflation Effect on Capital Budgeting Decisions. International Journal of Conceptions on Management and Social Sciences. 1(2) 2357-2787
Fylstra, D., Lasdon, L., Watson, J., & Waren, A. (1998). Design and use of the Microsoft Excel Solver. Interfaces, 28(5), 29-55.
(Fylstra, Lasdon, Watson & Warren, 1998)
Jan, I. (2013). Net Present Value (NPV).
Retrieved from: accountingexplained.com/managerial/capital-budgeting/npv
Gad, S. (2015). Capital Budgeting: Capital Budgeting Decision Tools. Retrieved from www.investopedia.com/university/capitalbudgeting/decision-tools.asp
Winston, W. L. (2015). Using Solver for Capital Budgeting. Retrieved from https:/support.office.com/en-nz/article/Using-Solver-for-capital-budgeting-dff4743d-72e4-49d5-a917-19d437efae88>
