How Firms use Capital Budgeting to Make Decisions Essay

Submitted By Christine-Oladoyin
Words: 5130
Pages: 21

How Firms use Capital Budgeting to Make Decisions:
Following the American Psychological Association’s Guidelines

Abstract
Capital Budgeting is a process that managers of companies of all sizes use day in and day out to make decisions on possible future investments or projects the company will be embarking on. It is important that there is a set plan in place and procedures so that management can have a way to evaluate how beneficial a new project will be. New projects are often introduced to management by consumers and existing customers. Also, new innovation often leads management to discover the need to take on a new project. After deciding to take on the project management must determine the cost of the new project and the financial obligations that the company will have to sustain with the new project. Afterwards, management must choose between five types of capital budgeting methods: net present value, internal rate of return, payback period, discounted payback period, and profitability index. They will then determine which method will work best to help them make good decisions on choosing new investments for their company. Once they choose their method they can then use it to determine the future cash flows, the profitability, how it may or may not affect other projects the company chooses in the future as well as how risky the project may be. Lastly, a breakdown of how often each method is used and preferred by companies is provided at the end. Majority of the research conducted for this paper was done so online and by use of the text book.

Research
Capital budgeting is a decisions making process that managers of firms have to make each and every day. This decision calls them to decide whether or not it is a good business decision to acquire long-term assets for the firm or if a project should be pursued. Sham Gad describes capital budgeting as “the step by step process that businesses use to determine the merits of an investment project.” (2012) A company decision to take on a project or acquire an asset is based on the rate or return on the investment made. What rate of return is acceptable and not acceptable is based on that specific firm and the project they chose to invest in. The use for capital budgeting in the manufacturing industry may be different than the use of it in the service industry, but no matter how it is used it is important to note manager use to it create accountability and measurability. The measurability factor allows firms to be able to measure and evaluate the risk of taking on the new venture. (Gad, 2012)
Although the funds used for capital budgeting are often not restrict and infinitely available companies must still carefully budget and plan the uses of these funds and make sure to choose and investment that “will enable the firm to generate revenue several years into the future.” (Keys, 2009)
Timing is often a key factor in making decisions about capital budgeting because a bad decision can impact a company’s future operations for years to come; it is imperative that managers take their time to make informative decisions about what project is best for the company to undertake. Planning is everything because projects often take several years to implement mangers must ensure the decision to take on a project does not start too early or too late. “If firms do not plan accordingly, they might find that the timing of the capital budgeting decision is too late, thus costly with respect to competition. Decisions that are made to early can be problematic because capital budgeting projects generally are very large investments, thus early decisions might generate unnecessary cost for the firm.” (Keys, 2009) Capital budgeting is useful throughout the timing of the entire project, from the beginning when it starts off as an idea that goes through various levels of authority where it decisions are made to either accept or reject the project to the very…