In an enterprise, capital budgeting is the process of deciding if capital assets are a worthy investment (Bierman & Smidt, 2012). These assets are usually part of the enterprise’s long-term investments like the latest equipment, warehouses, facilities, and patents. It should be noted that capital assets are beneficial in the long-term, but are essential to the enterprise’s strategic planning. This means that financial managers need to be intimately familiar with the different methods of capital budgeting, including how to select the best one to use in a future capital investment.
One capital budgeting method is the internal rate of return, which determines is a capital investment is worthwhile by projecting its interest over a certain time period in the future. The internal rate of error can be calculated by trial and error, thus helping financial managers and investors to establish and predict the future profitability of an investment (Dhavale & Sarkis, 2018). Another similar capital budgeting method is the Net Present Value (NPV), which compares the current value of money going into an investment and the current value of the money being spent (Gaspars-Wieloch, 2019). A positive NPV shows that the investment is worthwhile because its revenue generating capacity is greater than the costs and risks involved in the investment.
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Other capital budgeting methods are the profitability index, accounting rate of return, and the payback period. Each method has its uses and value to a financial manager and investor. A good example is any conventional restaurant immediately after the COVID-19 pandemic. As foot traffic reduced, there were fewer customers coming in for meals. At the same time, demand for online ordering and delivery of food increased. A financial manager for a restaurant chain might then use the different capital investment tools to determine if online delivery is the enterprise’s future. The investment would be to establish the technological infrastructure for online ordering and customer relationship management, create human resource policies for the delivery agents, and upgrade their kitchens and equipment as recommended by applicable COVID-19 prevention regulations.
In such a case, I would use the internal rate of return or the net present value to determine if the capital investment is worthwhile. However, I would also like to know how much the restaurant chain stands to profit from the investment in the long-term and when the investment will earn back the resources that went into upgrading the restaurants. As a result, I would use the accounting rate of return for the former and the payback period for the latter. The capital investment will involve ongoing costs, some of which will be variable. For instance, the cost of creating, maintaining, updating, and upgrading the technological infrastructure to facilitate online delivery of quality foods and customer relationship management platform will change with time. Furthermore, if the company is to facilitate online delivery of food, it will have to set aside resources to maintain PPEs for all the relevant personnel. These costs will reduce the profit margins and increase the payback period. After all, the increased fixed and variable costs will reduce revenues, thus increasing the length of time required to recoup the initial investment. Therefore, before making the investment, a financial manager will have to determine the investment’s net present value.
Response to Bryan Ziegler
Hi Brian,
I agree with your explanation of the net present value capital budgeting method. It is highly intuitive, especially the cost of the missed opportunity being behind the time difference in the value of money. You write that $1000 received today is worth more than $1000 to be received in 1 year due to the missed opportunity. Inflation is another influencing factor, where the time difference in the value of $1000 will also be different. In that case, the value of the money tomorrow will reduce.
Regardless, I like the example you provide, because it directly applies a capital budgeting technique known as the payback period. Companies and investors are not altruistic entities or philanthropists. As a result, every value in capital invested in a venture is expected to provide equivalent or higher returns. As a result, investments with shorter payback periods are highly desirable and more worthwhile because they are exposed to lower risks. This rule does not apply everywhere, unfortunately. An integrated chip manufacturer with an up-to-date foundry is a strategic resource that is virtually guaranteed to provide returns in the long-term. After all, computer chips will continue to be in demand as technology continues to play even bigger roles in our lives. Therefore, significantly longer payback period does not factor in when making the decision.
Response to Stephanie
Hi Stephanie,
I agree with the contents of your post. When it comes to capital budgeting, my main focus is on the different methods, where, and how financial managers can use them. Your post gave me a different perspective, I started to think about the practical aspect. From this week’s materials, we know about the different capital budgeting methods. Thank you for including the different steps to follow when creating and implementing a capital budget.
Note, however, that some of the steps are a bit ambiguous. For instance, I can fill in the blanks for step 2. However, you have not elaborated on how a company can decide whether the investment is a good move. From my research, two capital budgeting methods can help with the decision: internal rate of return and net present value. Each method has its strengths and weaknesses, making it a choice to be made by the financial manager based on their context. For instance, the internal rate of return can easily help said financial manager determine if a capital investment is worthwhile. However, it is limited by the fact that all calculations are based on trial and error.
Overall, I like the focus of the post, especially. You chose to use an example from your personal experience the demonstrates the power and importance of capital budgeting in determining a company’s future. For instance, had Modern Warriors have used their new space for other things, like build their headquarters and move all their operations to the new space, they would have never been in a position to enjoy such success in such a short period of time. By converting their new space into an 8,000 square foot show room, classroom, offices, a shipping and receiving section, photo booth room, and multiple vaults to store inventory, as well as a work shop area for fixing firearms or installing parts that customers have purchased, it is clear that the company properly applied the correct strategy for capital budgeting. While such details are not publicly available, I believe that a systematic approach to capital budgeting like your six steps can help companies apply capital budgeting techniques and gain success like Modern Warriors.
References
Bierman, J. R., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects . Routledge.
Dhavale, D. G., & Sarkis, J. (2018). Stochastic internal rate of return on investments in sustainable assets generating carbon credits. Computers & Operations Research , 89 , 324-336.
Gaspars-Wieloch, H. (2019). Project net present value estimation under uncertainty. Central European Journal of Operations Research , 27 (1), 179-197.
