Introduction
Cost of capital and capital budgeting are techniques that entail the efficient allocation of capital finance functions. Therefore, the techniques involve the decisions that commit to the firm’s fund towards long-term assets. It has been established that capital budgeting entails various benefits for the firm hence should be considered since the techniques tend to determine the value of the firm by influencing the growth, risk, as well as profitability (Baker 358). Besides, the evaluation describes how the decision made could be diversified. Therefore, this report seeks to analyze the cost of capital and capital budgeting techniques to understand their applications in organizational management. A review of the literature to evaluate the findings by other researchers will carried out to discuss the different technique of capital budgeting as well as its advantages and limitations. To fully present an understanding of knowledge learned, a case study of Coca Cola Company will be used to show the benefits of various capital budgeting techniques The analysis demonstrates that capital budgeting can be used by organizations to cut expenditure and increase sales.
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Literature Review
Generally, there are several criteria that are used by managers to conduct capital budgeting: payback period, accounting rate of return, internal rate of return, profitability index, (IRR) and net present value (NPV) (Truong et al.). Notably, these decision criteria in capital budgeting are calculated measures that can be used to compare the cashflows of various alternatives or projects. Before a specific decision criteria is chosen, it is vital to gain a comprehensive understanding of the technique. This section examines the aforementioned criteria and summarizes scholars understanding of the concepts and their advantages and disadvantages.
Payback Period
The payback period (PB) is defined as the anticipated period of time that is takes for the mean positive cash flows to be equal to the initial cost, or the time it is predicted to recover from the initial investment (Linstrom 1). In order for managers to utilize this technique, a cutoff period is set and all company projects with payback periods shorter than the cutoff periods are accepted and the ones with longer cutoff periods are rejected. The payback period method is popular among contemporary managers as it is simple and easy to use. Furthermore, the payback period technique minimizes risk in company projects as it saves managers the trouble of forecasting cash flows over an entire project’s life. The payback period method can also be used in ration the resources extended to different projects within the firm. Nevertheless, the payback period method of capital budgeting has some limitations. The payback period technique does not put all the cash flows after the payback period under consideration and thus does not consider the time value of money. This is attributed to the fact that the method simply adds cash flows at different points in time and compares them with the initial report.
Accounting Rate of Return
The accounting rate of return is defined as the average after-tax profit divided by the initial cash outlay (Kadondi 1). In utilizing this technique, managers select projects with the highest accounting rate of return. The accounting rate of return is advantageous as it uses the familiar percentage concept and examines the profitability of company projects. Nevertheless, the method is also disadvantageous as it does not take into account the timing of the cash flows as well as the individual project’s cash flows in respect to accounting income.
Internal Rate of Return (IRR)
The internal rate of return and the net present value represent two the sophisticated techniques of capital budgeting. The IRR is described as a measure of the return generated by a project or the rate of discount that ensures the present value of the projected future cash flows to precisely equal the initial cost of the project. Typically, an IRR value greater that exceeds the opportunity cost of capital indicates that the project can be accepted. According to Kadondi (1), the internal rate of return has multiple disadvantages the main one being that it does not conform to the value-additivity principle and subsequently eliminates the ability to evaluate projects independently. Furthermore, the internal rate of return assumes that capital invested in projects have an opportunity costs equal to the projects IRR. Accordingly, this assumptions violates the need that cash flows can be discounted at an opportunity cost of capital determined by the market. Overall, the internal rate of return can have negative effects and multiple rates of return any time the sign of cash flows alters more than once. This problem has been solved by the net present value technique.
Net Present Value
The net present value (NPV) rate is considered one of the most reliable capital budgeting technique as it solves multiple shortcomings of the other methods. The net present value is described as the present value of all the current and future predicted positive cash flows. Typically, the net present value method specifies that projects with an NPV value greater than zero are worth consideration. A positive net present value indicates that the company’s projected cash flows show an excess return in the discount rate (Truong et al.). Consequently, any company project that delivers an excess of the opportunity cost, adds value to the company (Farragher et al. 1). The net present value considers the riming of all the cash flows as a measure of the value added by a project as well as its addition to company value. By adding these two net present value mangers ae able to determine the added value of various projects.
Oki and Sivaruban (1553) noted that one of the major pillars of finance theory is that the value of an asset or a particular investment is equal to the discounted present value of the firm’s nature of the cash flows. The Net Present Value (NPV) presents that when the value of the project’s future cash flows exceeds the project cost, then the organization should consider the project (Truong et al.). However, in case the value is less, then the organization should not accept the project. These variables explain the cost of capital and capital budgeting techniques and formulas used in the application and evaluation of the methods (Madura 475). The values include the discounted rates which should be applied as an opportunity rate of return that is measured by the weighted average capital cost of the organization. Another approach that is used in the techniques is the adjusted present value (APV) which evaluates the cost of capital of the projects. This method seeks to expand the advantages of real options analysis due to the inability of the NPV method to capture the managerial flexibility value.
The use of capital budgeting techniques enables organizational management to expand, delay, or even abandon or close temporarily of a project. These decisions are made based on the options that will ensure the value of the project is equal to the NPV and the value of the strategic option. Studies by Oki and Sivaruban (1553) established that capital structure does not impact on the value of the firm. The study assumed that there were no taxes and that the capital markets were perfect regarding the investment and the financing decisions. However, based on some restrictive assumptions, the decisions regarding the capital structure of the firm can affect its value as explained in the trade-off theory. In such cases, the firms target the debt to equity ratio that seeks to maximize the firm’s value through the balancing of the incremental interest tax (Truong et al. 4). In such cases, the free cash theory highlights that management has a tendency to overinvest in the poor projects while the use of debt gives management discipline to invest in NPV positive projects.
Advantages and Disadvantages
Capital budgeting entails decision-making procedures for the most vital and critical business decisions hence the need to take absolute care in their treatment. Such critical decisions have an imperative role in the competitive position of the firm and the profitability of the firm. Capital budgeting decisions are against the strategic and investment decisions that can have an adverse effect on the firm (Peterson and Fabozzi 57). These include the management of the fixed assets. A properly done capital budgeting enables the determination of the future of the firm hence proper decisions can be made that yield spectacular returns. It should also be noted that the capital investment decisions affect the organization regarding the long-run cost structure of the organization. When the structures are done successfully, the organization will significantly benefit. However, if implemented improperly, they can have adverse effects since some of the considerations are not practically true. Some of the organizational factors like the employee motivation and goodwill cannot be correctly quantified hence impact on the capital decisions substantially.
Conclusion and Recommendations
The cost of capital and the capital budgeting techniques have been noted to be essential in organizations regarding the management of the organizational financials and hence the strategic direction management. From the analysis, it was established that a new project only makes the organizational economic sense if the discounted net present value exceeds the expected cost of financing. By the use of the capital budgeting procedures, the organization makes the evaluations and compares the targets and the outcomes of every department.
The findings of the current research indicate that scholars and accountants have utilized both the traditional capital budgeting and discounted cash flow techniques. The traditional capital budgeting include the payback method and the accounting rate of return while the discounted techniques of capital budgeting represent the NPV and IRR. Most corporations prefer to use the payback method due to it simplicity followed by the NPV due to its effectiveness. The reviewed literature indicate that the utilization of capital budgeting methods are directly related to better financial performance. It is evident that the net present value has a positive relationship with a company’s return on assets. Nevertheless, some studies have indicated that the the use of capital budgeting techniques such as the NPV and IRR cause an insignificant relationship between performance and the cost of capital. It is therefore crucial to incorporate the use of different analytical tools to ensure successful performance.
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Works Cited
Baker, H K. Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects. Hoboken: John Wiley & Sons, 2011. Print.
Farragher, Edward J., Robert T. Kleiman & Anandi P. Sahu (2001 ).The Association Between the Use of Sophisticated Capital Budgeting Practices and Corporate Performance, The Engineering Economist, Vol. 46, No. 4, pp. 300- 311.
Kadondi, E.A (2002). A Survey of Capital Budgeting Techniques used by Companies listed at the NSE, Unpublished MBA project, University of Nairobi
Linstrom. L. (2005/ A portfolio Approach to Capital Project Management; Unpublished M.Eng dissertation, University of Pretoria.
Madura, Jeff. International Corporate Finance. Mason, OH: Thomson/South-Western, 2008. Print.
Oki, Frank, and Sivanathan Sivaruban. “Capital budgeting and cost evaluation techniques: a concept analysis.” International Journal of Science and Research vol. 79, no. 57 (2016): 1553-1557.
Peterson, Pamela P, and Frank J. Fabozzi. Capital Budgeting: Theory and Practice. New York, NY: Wiley, 2002. Print.
Truong, Giang, Partington, Graham, and Maurice Peat. “Cost of capital estimation and capital budgeting practice in Australia.” Australian Journal of Management (2008), 1-12.