Capital budgeting involves the process of investment appraisal that includes the planning process that is used in the determination of whether a firm’s long-term investments such as purchase of new machinery and acquisition of suppliers are worth the funding by the firm. Since it involves the allocation of funds for major projects it should be aimed at increasing the firm’s value to its shareholders. It is worth the consideration of this planning process since it involves large amounts of money, which in turn has a great influence on the firm’s profitability (Bierman& Smidt, 2014). In addition, such projects are usually long-term and thus, once made they are irreversible without significant losses of the invested capital. Such an investment usually becomes sunk, and as such mistakes, as opposed to being corrected, must usually be borne until such a time when the firm involved can be withdrawn through such processes as liquidation or depreciation of charges. Owing to the significant impact of capital budgeting on the firm, in this case EEC, it is important to consider an enhanced analysis of the feasibility of acquiring the supplier.
The process of analyzing the investment opportunity in the purchase of the supplier will be enhanced by the acquisition of a wide range of information that will enable the firm to make a viable decision on the capital project. Such information will include the cost of acquisition, which will be determined by carrying a valuation exercise on the firm to be acquired. It will be vital for EEC to determine the current value of the supplier so as to make a decision as to whether it should purchase the supplier in consideration of the firm’s financial capability (Bierman & Smidt, 2014).
In addition, the firm need to acquire information on its resource capability to carry out the capital project following the determination of the current market value of the supplier and other operation dynamics, the organization will need to determine if it is capable of financing and effectively operate the project both in the short and long terms. The firm needs to acquire information on the resources required to effectively run the supplier firm. Such resources may be in the form of finances, time, as well as human resources.
Capital projects have a great influence on the firm’s profitability as a result, it is important for the firm to have information on the returns of the project before making a decision on investing in it (Clayman, 2012). The firm should thus, collect information on the cost savings that will be achieved if it invests in the project.
So as to ensure that the firm does not risk its funds, it should take a step to acquire information on the prevailing market conditions, as well as competitive advantage levels to which the acquisition of the supplier will result in. Such will enable effective decision-making on the project since the decision makers will be able to get a glimpse of such factors as competition in the market and the manner in which the firm will be able to compete with other firms in the market.
Decision-Making Process and Capital Budgeting Techniques
The decision-making process in this case will involve a series of steps. Such will include gathering information on the project, especially in terms of the prevailing market conditions, current value of the supplier firm, as well as any future prospects on the project (Shim & Siegel, 2012). Following this process, it will be important to consider a number of other options including starting up a branch in EEC to cater for its supply solutions. The process will be effectuated by comparing the alternatives available and coming up with a final decision to purchase the supplier. It will also be important to consider the rate of return to assign the project so as to make it possible for the organization to plan for the investment effectively.
Different capital budgeting techniques maybe applied in making capital budgeting decisions (Bierman & Smidt, 2014). Such include the accounting rate of return (ARR) that is a ratio that gives the rate of return of a project that is generated from the project’s net income. It gives a ratio of the rate of return relative to the investment made and does not take into account the time value of money.
The payback period may also be used and refers to the period of time taken for the project to recover the amount invested. It thus, gives the measure of time taken for the project to pay the invested funds and does not take into account the time value of money.
The net present value (NPV) refers to the sum of the project’s present values of all the cash inflows and outflows over a specified period of time in the future. In this technique, time value of money is taken into account and provides that time has an impact on the value of the project’s cash flows (Osborne, 2013).
Net Present Value Calculation
Interest 14% Year Cash Flows
Year Cash Flows Present Value 0 ($2,000,000)
0 ($2,000,000) -2000000 1 500000 ($1,500,000)
1 500000 438596.49 2 500000 ($1,000,000)
2 500000 384733.76 3 500000 ($500,000)
3 500000 337485.76 4 500000 $0
4 500000 296040.14 5 500000
5 500000 259684.33 6 500000
6 500000 227793.27 7 500000
7 500000 199818.66 8 500000
8 500000 175279.53 9 500000
9 500000 153753.97 10 500000
10 500000 134871.90
Net Present Value ($452,539.59)
Internal Rate of Return 10.18%
The profitability index (PI) maybe used to determine the decision of making the investment in the project of purchasing the supplier. It gives the ratio of the project’s present value of its future cash flows relative to the initial investment. It enables decision makers to quantify the value that is created by a unit of the investment.
The internal rate of return (IRR) may also be used in making capital budgeting decisions. It provides the discount rate that leads to a case where the net present value of the project’s future cash flows is equal to zero. Projects with the highest internal rate of return are considered viable. In this view, the IRR is used as a means of ranking projects and determining which one to undertake.
Impact of Time Value of Money on Capital Budgeting
When a firm makes a decision to invest in a project, it may take a long period of time before such a project begins making positive returns. The firm thus, needs to know if the project’s future returns are worth the initial investment where such future cash flows are impacted by the aspect of time, which gives one of the reasons why time value of money is important in making capital budgeting decisions (Saita, 2007).
The time value of money accounts for the deviations in the value of a future amount of money in the future based on the time involved to earn or lose it. It thus, acts as a means of acknowledging receiving some money in the present and receiving it in the future. In most instances, risk averse individuals would prefer receiving a cash flow today as opposed to receiving it in the future due to the possibility of incurring an opportunity cost in the future. Due to the importance of the present and future values of an investment in capital budgeting decision-making, time value of money is a critical factor to consider. By making the option to fund an investment in capital budgeting, the firm will be denying itself the possession of such money in the present until the investment pays off in the future. Due to the change in the value of money in the future for capital intensive projects, it might sound better to invest money in a project and receive higher value in the future, which is through the impact of time value of money.
Capital Budgeting versus Regular Budgeting
Capital budgeting is mainly involved in making decisions regarding capital-intensive projects. Such projects require huge capital outlay and are long-term. In addition, once they are commenced, they are usually irreversible. On the contrary, regular budgeting deals with day-to-day operations and usually involves lower amounts of money to start off. Since the project by EEC to purchase the supplier firm is long-term and involves huge amounts of money, it will be important to use capital budgeting as a means of basing the decisions involved.