• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month
  1. 1
  2. 2
  3. 3
  4. 4
  5. 5
  6. 6
  7. 7
  8. 8
  9. 9
  10. 10
  11. 11
  12. 12
  13. 13
  14. 14
  15. 15
  16. 16
  17. 17
  18. 18
  19. 19
  20. 20
  21. 21
  22. 22
  23. 23
  24. 24
  25. 25
  26. 26
  27. 27
  28. 28
  29. 29
  30. 30
  31. 31
  32. 32

Capital budgeting: advantages and limitations

Extracts from this document...


´╗┐CAPITAL BUDGETING: ADVANTAGES AND LIMITATIONS. SEPTEMBER 2012 CHAPTER ONE INTRODUCTION 1.0 Background Study Capital budgeting is the process by which firms determine how to invest their capital. Included in this process are the decisions to invest in new projects, reassess the amount of capital already invested in existing projects, allocate and ration capital across divisions, and acquire other firms. In essence, the capital budgeting process defines the set and size of a firm?s real assets, which in turn generate the cash flows that ultimately determine its profitability, value and viability. In principle, a firm?s decision to invest in a new project should be made according to whether the project increases the wealth of the firm?s shareholders. For example, the Net Present Value (NPV) rule specifies an objective process by which firms can assess the value that new capital investments are expected to create. As Graham and Harvey (2001) document this rule has steadily gained in popularity since Dean (1951) formally introduced it, but its widespread use has not eliminated the human element in capital budgeting. Because the estimation of a project?s future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioural traits of managers still affect this process. Capital budgeting is a process that is used to determine whether or not certain projects are worthwhile investments. Another term for capital budgeting is called an ?investment appraisal.? Every firm has both a limited amount of capital available and a desire to deploy that capital in the most effective way possible. When a firm is looking at, for example, acquisitions of other firms, development of new lines of business or major purchases of plants and equipment, capital budgeting is the method used to determine whether one option is better than another. Although conceptually capital budgeting is simple to understand, creating a capital budget has some definite challenges. ...read more.


The use of the payback method as the only or the major method seems to be more commonly used in small and medium-sized companies (Longmore 1989). Various studies of the use of the payback method in investment evaluation have been done at different points in time but some of the recent overviews of various studies are presented by Lefley (1996). Although the results from different studies at different points in time are not totally consistent, the payback method seems to be more frequently used in Europe than in the United States of America. Most importantly the overall conclusion seems to reveal that the payback method is much in use by firms for investment appraisals and it is therefore necessary to reduce some of its deficiencies. Discounted Payback Period Method (Payback DCF) The payback method have gone through various development stages over the years, with the different variations aimed at eliminating some of its disadvantages and at the same time keeping the method as simple as possible. The payback method based on discounted cash flow figures was proposed by Rappaport (1965) which related the opportunity investment rate notion to the payback period measurement. This method attempted to overcome one of the drawbacks of the conventional payback calculation which failed to take into account a firm?s cost of capital. The discounted payback period method proposed by Rappaport is an improved measure of liquidity and project time risk over the conventional payback method and not a substitute for profitability measurement because it still ignores the returns after the payback period. He stated that, the proper role for the discounted payback period analysis is as a supplement to profitability measures and thus highlighting the supportive nature of the payback method, whether conventional or discounted payback period. Longmore (1989) also proposed a generalized time-adjusted payback rule which states that ?If the investment proposal?s payback, adjusted for the timing of the net cash flows, is less than or equal to the present value of annuity factor at the firm?s cost of capital for the life of the proposal, the investment should be accepted?. ...read more.


Firms try to avoid other appraisal methods like NPV, IRR and Real Options Approach because of the complexity that is built in them. It has also been found that, capital budgeting is an important aspect of a firm?s financial management. The importance of capital budgeting included, avoidance of forecast error, timely acquisition of assets. Capital budgeting can be a useful tool in the analysis of huge profits. However, there are serious limitations that must be considered when evaluating the results of these projects. These limitations can be used to manipulate the results of an otherwise unfavourable project and make it appear to have a larger return than it actually has. The study indicated one of the key limitations as its irreversibility. In other words, once a capital budgeting decision has been taken, it cannot be reversed. In view of this, crucial steps and analysis should be made before taking a capital budgeting decision. 4.3 Recommendations These recommendations were made based on the study. Firms should deal with uncertainty, a three-stage process: 1. Build knowledge through decision analysis. 2. Recognize and encourage options within projects. 3. Invest based on economic criteria that have realistic economic assumptions. Once the three-stage process (as outlined above) has been completed, capital projects should be evaluated using a mix of economic criteria that adhere to the principles of financial management. Three good economic criteria are Net Present Value, Modified Internal Rate of Return and Discounted Payback. Additionally, management of project risk should be different. Tools to manage risks include increasing the discount rate. Post analysis and tracking of projects should be implemented after the investment has been made. This helps eliminate bias and errors in the capital budgeting process. Firms should plan for funds far ahead of time. This makes capital budgeting decision by firms simpler when the time is due because the funds needed for the project are now available. Further studies and research by any individual or group are also recommended on topics relating to capital budgeting. This will broaden the horizon of capital budgeting and contribute substantially to economic growth and development. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our University Degree Accounting section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related University Degree Accounting essays

  1. The Importance of Communication in Accounting. Todays accountant, especially within the managerial accounting realm, ...

    (Green, pp. 209-213) Indeed, a well thought out, transparent and clear communication can be the difference between mitigation of damage or the worsening of this damage during reporting events such as, changes in estimates, correction of errors and financial restatements.

  2. Discuss the main theories of international finance and assess how each of them would ...

    goods and money markets, some real cross-border investment activity or change in trade patterns in the goods and services market. The speculators would move their capital from countries with low interest rates to countries with higher interest rates. This movement of capital would cause a movement in the foreign exchange rate.

  1. Equity gives certain powers and duties to trustees to enable the trust to be ...

    the case required for that the ordinary prudent man would it take if he were minded to make an investment for the benefit of other people for whom he felt morally bound to provide"24. This was approved in Bartlett v Barclays Bank Trust Co Ltd (No1)

  2. "Describe and compare the alternative methods that companies can use to raise capital in ...

    scope of our discussion therefore we discuss only some of the advantages and the problems with these instruments to companies and investors. 2.1 Advantages to company the advantages of issuing corporate bonds is that it "allow[s] private firms to borrow money directly from the public"2, this gives companies the incentive

  1. Management Accounting. A number of factors will influence the outcome of an investment appraisal ...

    3.1 Question 2 (a) a) Define responsibility accounting and comment on the application of responsibility accounting in the context of the above situation. In a manufacturing industry, there will be different processes to pass through before a product is completed.

  2. Define and analyse the advantages and disadvantages of the going concern, accruals and prudence ...

    Understatement of income can result in an overestimation of profit and this will have an indirect knock on effect in the future trends of profit (John Samuels, Colin Rickwood and Andrew Piper 1989:p13).

  1. This report will incorporate an analysis of Blackmores LTD including, the level of leverage ...

    which started in the 1930s is a major player in developing and marketing products and services that deliver a more natural approach to health, based on their expertise in vitamins, minerals, herbs and nutrients. Blackmores' first public issue was on 2nd May 1985, and the organization is presently listed on the Australian Stock Exchange (ASX)

  2. The topic I have chosen is the Business and financial analysis of a company ...

    Comparison with Sainsbury plc Sainsbury shows an opposite trend i.e. it has declined from 0.66 times in 2008 to 0.55 times in 2009.This may be due to increase in trade payables from £2280m in 2008 to £2488m in 2009. This can be a sign of bad working capital management.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work