Table of Contents
Introduction
Capital budgeting primarily comprises of selecting various projects by an organisation so as to add value to that business concern. It may also sparingly include insufficient equipment or production capacity. The decision pertaining to capital budgeting is definitely important, mainly because of its continuity for a longer period of time. In most cases, decisions are related to land acquisition, fixed asset expenditure, vehicle purchase, new equipment, plant reconstruction or replacement of old machinery. Expansions actually demand a higher amount of expenditure. Therefore, if capital budgeting is effective enough, then improvement can be witnessed for purchased assets’ quality and less cost incurring asset acquisition. In this report, thus it will be elucidated how several methods can be incorporated for capital budgeting. Moreover, a financial manager actually ascertains each capital budgeting method’s pros and cons before utilising the same. The role will be played as Tesco’s finance manager for this study.
Discussion
Methods pertaining to capital budgeting
There are various methods or techniques for taking decisions relating to capital budgeting. Even though such different techniques persist, financial managers choose only two or three robust ones. For instance, the payback period method is considered to be one of the easiest and prime capital budgeting techniques. The basic aspect in this method is none other than the amount of time required for a project’s completion and recoup funds utilised for the capital project is determined by payback period method. It is deduced by dividing amount of total expenditure by a specific time frame pertaining to investment recovery.
On the other hand, net present value is another method of determining a capital project’s feasibility. It determines whether benefits are much more than that of costs thereby determining progress path. The financial manager of an organisation must determine return on investment and then compare the same with cost of capital. Thus, former one should be mandatorily higher than the latter one mentioned above. Furthermore, ROI must be comparatively more than investment risk premium. Therefore, NPV is computed by merely subtracting costs’ present value from benefits’ present value of a particular capital project.
Another important and popular technique chosen by several financial managers throughout the world is IRR or Internal Return Rate. However, it is often perceived to be more complex in nature than the above mentioned two other methods. IRR is the interest or discount rate which makes an investment’s income stream sum to zero. On the contrary, this income stream can be calculated by summing up total cash flow pertaining to a project. Initially, cash outflow starts as negative whereas benefits or interests that are received each and every year mostly get listed as positive. After the completion of project investment, value is added with initial investment’s negative value figure along with yearly interest amount. IRR is the discount percent which adds up all these figures thereby resulting in zero (Kaplan Financial Limited, 2012). Thus, it is considered to be extremely helpful for contrasting and comparing two distinct or alternative capital projects or investments.
Both the calculation and concept of Profitability Index can be said to be similar to that of NPV. The technique is largely useful for determining value of a project and its expected return to a company within a specific time period. PI can be referred to as the current value’s ratio of cash flow in future to that of initial investment.
Advantages
There are various advantages of using the NPV method. One of the obvious advantages is inclusion of an idea where it is deciphered that a pound’s worth is always more at present than what it will be in future. Thus, in each period, another period pertaining to cost of capital helps in discounting cash flows. It further assists in elucidating whether an investment can create value for any investor or the company or not. For instance, if 15,000 pounds are invested for surging a company’s value by almost 3443.70 pounds, then the computation is not valid. A finance manager should portray how all the cash flows are actually discounted back as per present day’s value. While projections are made for the future, NPV method takes into consideration both inherent risk and cost of capital. Alternatively, a projection made for next year is accurate than the projection prepared for a 10 years’ project (INR, 2017). NPV is less affected by the cash flows that can be witnessed in the farthest of future. On the other hand, earlier period cash flows can affect NPV.
Similarly, like the previous one, advantages of IRR can also be retrieved sparingly. For instance, time value of money is definitely considered in case of IRR. In this case, interest can be considered as the value of time. Undoubtedly, it should remain high because people or investors are sacrificing their hard-earned money for a particular span of time. Thus, expected high interest rate is deciphered by IRR. Apart from this, it is substantial because all the cash flows are considered to be equally important. Thus, relationship with different rate is created by the finance manager so as to know where cash inflow pertaining to the present value becomes equivalent to cash outflow. On the contrary, there is hardly any base for particular rate selection in IRR. Shareholders’ profitability is always the primary concern in this method. For example, if a single project is in focus then its cut-off rate should be lower than IRR, which displays a vivid profitability for the shareholders (Petty, Titman, Keown, Martin, Martin and Burrow, 2015). Calculation for cost of capital is also not required in this method, especially when without the same profitability capacity can be checked.
Payback period method is actually quite easy and simple for incorporating and also for calculating. It is used universally. The method emphasises on liquidity pertaining to decision making and investment proposals (Bierman Jr and Smidt, 2012). Risks are part and parcel of payback period method. However, the projects that have shortest payback period are quite less risky than their counterparts. On the contrary, short-term approach taken by payback period definitely comes in handy for capital expenditure calculations.
Disadvantages
The disadvantages pertaining to NPV cannot be negated at any cost. Sometimes guess works are required for determining any firm’s capital costs. On the other hand, suboptimal investments can be noticed when excessively low cost of capital is considered. Alternatively, higher cost of capital assumption can lead to several good investments’ abandonment.
Furthermore, when two projects of varying sizes are compared NPV cannot be used for the same, especially when the resultant NPV provides an answer in currency units whereas input size determines NPV’s output size (Brigham and Ehrhardt, 2013). For instance, NPV of a 1000 pounds million project is supposed to be less than a single pound million project. However, the return for the prior one is definitely higher. Thus, in case of scare capital NPV method is not applicable and more so when size of projects are distinct from one another. Immediate comparison is not possible merely by concentrating on present days’ output.
There are varying ranges of disadvantages of IRR as well. For example, understanding IRR is quite difficult. Its difficulty level increases when two distinct experimental rates are considered for unequal cash inflow’s value at present against its outflow’s value. Assumptions made are at times not that realistic in nature. The assumption is that if money gets invested on IRR right after receiving profit then easily that can be reinvested as well on the same IRR, which is quite not possible in real-time.
At times, a dilemma can be faced by the finance managers in case of investment. For instance, a coercive environment can be created for investing in different projects when a particularly important one is under evaluation (Goodman, Neamtiu, Shroff and White, 2013). In real life scenario, it can be seen that if a company wants to manufacture 1000 shirts in three days then both bigger space and labour force are required. Therefore, before investing in human resource, a new factory should be bought for production purpose (Kengatharan, 2016). As a result, these projects are known as the contingent or dependent projects; considering them is definitely important for any business. In these types of scenarios, there is a possibility that IRR allows to invest in the new project but if maximum benefits are exhausted for investing in plants then the same serves no purpose of profitability.
Mutually exclusive projects are extremely important in case of their selection. It simply means when one project is taken into account the other one must be excluded. Thus, which one is more feasible must be calculated beforehand. However, IRR will therefore provide a percentage interpretation proposition which is hardly adequate. Economies of scale are further ignored in IRR method.
Contradictorily, the disadvantages related to payback period are also evident to a large extent. Once again time value of money hardly gets recognised in payback period method calculations. Profitability, on the other hand, gets ignored thereby focusing on liquidity. Cash flow that comes before payback period is mostly considered.
Link between costs of borrowing and capital budgeting
Cost of borrowing is primarily referred to as a debtor’s total amount payment for securing a loan. However, funds are also used sparingly which include account maintenance, financial costs, loan-related expenses and loan origination. On the other hand, sums on cost of borrowing actually appear as amounts, whether it is in terms of euro or pounds. On the contrary, cost of capital is payment done by an organisation for raising funds such as issuing bonds or taking bank loans. It appears as annual percentage.
Cost of capital is directly linked with capital budgeting on the other hand. The charges that the debtor is paying can be of varying types such as bank charges or interests. Sometimes it is capital market which determines these rates. Contradictorily, borrowing cost is related to NPV and IRR as well. Discounted rate aspect is important as it pertains to the money’s value at present and future periods. Common methods for evaluating discounted rate are cost associated with the money borrowed and use of expected return in respect of investment choices (Rossi, 2014). In such scenario, in order to raise fund for a stipulated projects borrowing money may be required which ultimately links with cost of borrowing. Moreover, the organisation then plays the role of a debtor. Borrowing costs furthermore change over time and thus total dependence on current averages may ultimately lead to inappropriate capital cost calculations.
In companies of U.K., there is a disparity between capital budgeting practices and theories. A study of 300 companies existing in U.K. demonstrates that few of the organisations do not use formal risk analysis and discounted cash flows for capital budgeting (Andor, Mohanty and Toth, 2015). On the contrary, finance managers of these U.K.’s organisations prefer using various thumb techniques for selecting feasible projects.
In Tesco’s financial reports, it can be witnessed that interest-bearing borrowings are present. Tesco’s 2016 balance sheet deciphers that borrowings were of 2826 million pounds, where overdrafts, bank loans, commercial papers and joint venture loans were included. Therefore, it portrays that both in bank and joint ventures the company is liable to pay interests on these borrowings (Tesco PLC, 2016). On the contrary, Tesco has several projects, right from Tesco Bank to Tesco Mobile. All these are considered to be important for the company and that is why loans can be surely taken for them. As a result, capital budgeting decision is largely related to bearing cost of capital.
Conclusion
Ideally, it is better to pursue all the opportunities and projects which enhance values of shareholders of any organisation. Capital amount is however restrained in most cases and thus opting for new projects is not possible every time. Therefore, it is the jurisdiction of management to determine appropriate budgeting techniques so that optimum amount of return on investment can be deduced. However, if any investment does not decipher adequate return then the same can be rejected by the management members sparingly. In the above paper, it can be witnessed how IRR is actually easy and more appropriate for adopting in capital budgeting decisions.
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Summary
In this paper, it can be witnessed that capital budgeting decision is extremely crucial for an organisation because future profit margin increase dependence on the same. The more return on investment, better is that project. Cost of capital should always be less that future benefits extracted from a project. Several methods are discussed in this paper pertaining to capital budgeting decisions via which Tesco’s finance manager determines which project is more feasible. Furthermore, he has to keep in mind cost of borrowings as well. If the cost of borrowings is more than projected ROI, then investing in such a project is merely a waste of time. On the contrary, Tesco’s financial statements show hefty amount of borrowings for which costs have to be borne by the same in due course of time. The techniques that take into account the concept of time value pertaining to money are always the best ones. However, at times finance managers select the method which is easier to calculate and deduce results. On the contrary, it can be further observed that some firms of U.K. do not prefer using the conventional capital budgeting methods rather they feel comfortable incorporating thumb rules pertaining to project selections. Therefore, it can be inferred from this report that it is personal preference of the companies’ top most leaders to choose project feasibility calculation methods. Contradictorily, it can be said that profitability and shareholders’ interests are prime focus of Tesco’s finance manager, irrespective of capital budgeting technique adoption.
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