How to Do Capital Budgeting for Your Business

Microsoft Corporation Operates under an operating income of US $22.27 billion with a revenue before tax of US $89.95 billion, the net income of Microsoft is $21.20 billion with the total assets of US $241.08 billion and equity of US $72.39 billion. The information on the financials forms the basis of analysis of Net Present Value, Internal rate of returns, Modified Internal Rate of Return, and Weighted Average Cost of Capital. The information also forms the basis of cash flows for Microsoft companies from the year of 2011 to 2017, a period of 7 years. The hypothetical capital budgeting process will focus on the rate of return on the investments of Microsoft Corporation, the net present values of the investments made by the Microsoft Corporation. Measurements of payback period of the investments are essential in determining the operations and capital budgeting in the business and making the required investment decisions (Abor, 2016). 

The hypothetical capital budgeting of Microsoft Company starts from an initial investment of 2011 with a series of cash flows and evaluated in 2017, a period of seven years. Analyzing the investments is based on the cash flows of the company which measures the difference between inflows and outflows over the period, a net present value which measures how the operations of the investments are valued at the present time since the series of investments are made. Taking a seven-year period to be the measurement of the investment by Microsoft then their series of cash flows are presented in the table below. 

Figure 1: Cash flow statements, Values in thousand US dollars 

From the cash flows, net income of the company has been flowing in a manner that it is fluctuating from increased income to a decreased recorded income.2013 was the highest income recorded at $23,150,000 and the lowest income was during the 2015 financial year which witnessed a net income of $12,193,000.The cash flows are from the investing activities, financing activities, and operating activities. The series of low cash flows of the company may be due to using of the systems which are not yet automated, overspending, non-prioritization in the projects, and employment of measures that do not improve the efficiency of the businesses (Abor, 2016). The impacts of expanded costs on the company and the improper management of employees are also essential. 

Taking the initial investment of Microsoft to be the cash flow of 2011 and the subsequent cash flows as series of investments than for a period of 7 years then the internal rate of return for the 7 years will be 41%. Assuming that the initial investment is the cash flow in 2011 then the internal rate of return in successive years would be 41%, this implies that the company’s desirability of the investment stands at 41%. Decisions can, therefore, be made for the management to either maintain or improve on the existing technologies applied by the corporation. Based on the 7 years that the Microsoft is operating then the net present value is $7,547,969.40 while the MIRR is 19%, this is obtained assuming that the discount rate is 8% and the rate of investment is the same as the internal rate of return which is 41%. 

The Net present value of $7,547,969.40 is a positive net present value that implies that the overall revenues gained by Microsoft over the 7 year period are higher than the amount that is used as the cost of the projects. The cash inflows are also higher than the cash outflows by the amount implied by the net present value. This implies that the Microsoft investments over the last 7 years are healthy and shows the potentials of increasing upon mechanization. From the cash flows, there has been a reduction in net cash flow from 2011 to 2013 after which there was an increase in cash flow between the years 2013 and 2014, there was a decrease in cash flows afterward. 

Based on the cash flows there has been a decrease in the cash flow since the initial investment assumed to be the initial cash flow in 2011. The decreased cash flows indicate that the business and the activities of Microsoft has been on the downward improvement which indicates that the business has been less attractive based on the series of low investments that have been witnessed. However, the net present values of the operations remain positive which indicates that the Microsoft has the potential of increasing its operations. However, “ positive idiosyncratic shock decreases the sensitivity of firm value to priced risk factors and simultaneously increases the firm size and idiosyncratic risk”(Babenko et al. 2015, p 32). 

To improve the operations of Microsoft Company there are measures that must be done which are geared towards automation of the tasks, measures that limit interruptions and measures that promote the use of face-to-face interactions. However, the delegation of duties is also essential in ensuring that the efficiency in the production process is maintained. Automation of the operations system includes coming up with modern machines in aiding production process or improving already existing machine operations with the objective of replacing the old and ineffective systems. Improving the operations of the business starts with checking on the capital which includes the machine, as well as, human resources. Organizing, planning, and proper coordination of activities ensure that there is efficiency in the business. 

Maintaining minimum cash in the company such that the company does not face liquidity problems is also one of the ways that the company may avoid the current liquidity problems that it faces. Maintaining liquidity ratio works by ensuring that the company does not lack the amount of cash which is required to meet short-term obligations of the Company. Improving the cash in the company's operations does not make the company operate at minimum levels in the form that the company cannot pay some of its current debts. When the company improves this amount then there is a probability of raising the internal rate of returns to 60% which is desirable. 

Microsoft Company must also reinvest in other activities in order to raise their internal rate of return to a value of 60%. An internal rate of return of 60% is desirable compared to an internal rate of return of 41%. A higher return which exceeds the company's internal rate of return for the company should always be accepted (Vernimmen et al. 2016). The company must, therefore, engage in those projects whose returns are higher than 41% or higher than the company’s returns. The rate of reinvestment must also be high. The internal rate of returns also influence the equities in the same way the equities of Microsoft company affects the equities. This is also essential in raising income for the business and also in determining the shareholding of the business. 

Microsoft must also ensure that the expand the markets by concentrating on the sales efforts and on the ways which promote sales of the company, the company must also review their offer with the objective of boosting productivity, purchase more effectively, and manage the costs involved in the productions in the company. Managing costs involves measures that avoid unnecessary costs for the businesses and those measures which avoid financial wastage for the company. Management of costs ensures that the cash outflows are contracted while the cash inflows are expanded. Expansion of inflow and contraction of outflow helps in raising the cash flow of the business, therefore, making the internal rate of returns to tend towards 100% which is desired. In this case, the company will start by operating at a minimum liquidity and avoid the liquidity problems that are identified with the companies ( Vernimmen et al.2016). 

In budgeting for the Microsoft Company, projects which have higher returns that the internal rate of returns of Microsoft should be accepted, they are the most desirable projects. The projects whose returns are equal to the company's internal rate of returns have the high-risk propensity and can go either way in terms of profitability, therefore, they should be avoided if the situation of the business requires risk-averse culture. Projects whose returns rate is lower than the company’s internal rate of return should be avoided since they present great risks of losses due to the low returns. These projects are likely to take more of the company’s investing finance. 

Reference 

Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In  Entrepreneurial Finance for MSMEs  (pp. 293-320). Palgrave Macmillan, Cham. 

Babenko, I., Boguth, O., & Tserlukevich, Y. (2016). Idiosyncratic cash flows and systematic risk.  The Journal of Finance ,  71 (1), 425-456. 

Vernimmen, P., Le Fur, Y., Dallochio, M., Salvi, A., & Quiry, P. (2017). The Internal Rate of Return.  Corporate Finance: Theory and Practice, Fifth Edition, Fifth Edition , 284-296.