Capital Budgeting Assignment: A Case Study Analysis
Question
Task: Conduct a case study analysis of the role of formal evaluation techniques in the decision making process and prepare a capital budgeting assignment?
Answer
1. Interoduction
The concept of capital budgeting process explored in the present case scenario of capital budgeting assignment includes presentation of cash outlays in expectations of the benefits or net cash inflows arising later on (Rossi, 2015, p 50). Capital budgeting decisions in project management enables identifying key aspects of scope, scheduling and cost management to be adopted as per best project management practices (Fehrenbacher et al, 2020, p 100650). Project management development through planning of a project and controlling reports allows analysing a project case and also develop constraint management plan. In the current project analysis, the understanding of capital budgeting by review of two capital investment decisions undertaken by south African firms has been considered. The findings of the case ascertains that managers in their capital investment decisions does not focus on comparing the expected value of potential investment opportunities as suggested by theory (Gilbert, 2005). While undertaking a decision of capital budgeting, then a multi-stage filtering process as well reducing the list of projects by establishing alignment with the strategic goals on a qualitative approach. One of the most preferred approach is the discounted cash flow project evaluation methods which can confirm selected projects for attaining expected satisfactory levels in financial performance. This evaluation approach has been discussed in the current case analysis provides better understanding of the unexpected limited usage of discounted cash flow techniques by managers while making capital investment decision making. Thus, the cost structure used in the case, factors that affected the decision beside the cost along with critical evaluation is undertaken to arrive at findings related to the case.
2. Background Of The Case Study
2.1 Cost Structure
There are various types of cost structures that involves capital budgeting decisions for arriving at expected value that a project can create. In the current case study, there are two cases undertaken to evaluate the role of Discounted Cash Flow technique (DCF) to arrive at the decision-making process. In the first case Firm-A, which planned for relocation of its production facility was primarily ascertained due to loss of cost advantages. The firm aimed at relocating to possible locations such that it can optimise its cost structure decision. There are three cost factors that comes within the cost structure, it includes fixed cost, variable cost and incremental costs (Horngren et al, 2015). As the company had high levels of fixed cost as well as variable costs also certain components of incremental costs, it led to the firm’s decision to relocate. The areas both domestic and foreign locations which selected was however not very cost-effective. These locations were mainly selected on the basis of strategic choices. Capital budgeting process that was used for evaluation of the firm’s decision was DCF technique.
Firm B decided to expand its capacity, which undertook capital expenditure proposal at its divisional level with permission had to be obtained from the group level. The company aimed at producing at lowest possible costs by not over-capitalising itself. The firm considered payback period (PP) for determination of the attractiveness of alternative as they were not comfortable with DCF technique. Also, IRR methods was selected for analysis of alternative for capital expenditure decision. In this firm’s scenario PP and IRR technique was used for evaluating the firm’s decision in this case.
2.2 What Are The Factors Affecting Decision Beside The Costwithin This Capital Budgeting Assignment?
In the case study analysis for both the firms involved various factors apart from cost consideration that led them to decide on relocation of production facility and to expand its operations. For Firm A, major factor that affected their decision to relocate their current facility apart from costs includes low levels of productivity with increasing importance of export sales. Another crucial factor that led to the decision for relocation of its factory is due to receipt of governmental incentives in direct as well as indirect costs being discontinued. These have led to difference in productivity levels leading to consideration of identifying possible relocations (Daunfeldt, and Hartwig, 2014, p 110).Thus, apart from Capital financing and allocation functions other considerations during the Capital Budgeting Process included was low productivity levels and increasing importance of export sales.
In the Firm B’s decision to expand its capacity was mainly based at the divisional level as the Tissue Division had the largest share of the market accounting for 37%. The management of the company diagnosed capability of product differentiation hence profitability to operate in high efficiency to have continued market dominance.Factors considered apart from Capital financing and allocation functions during this Capital Budgeting Process includes its interests to dominate the market in sustainable manner.
2.3 Critical Evaluation
In the case study for both the firms, there have been managerial consideration that has led to consideration in the Capital Budgeting Process. In Firm A’s case, managerial consideration that impacted decision for relocation of the production facility of the firm was mainly due to promoting its exports from current levels as well as minimisation of costs. Managerial decision consideration for the factor for relocating production facility was also sustained growth in the domestic market and opportunity in the international market, this will provide the company opportunity for diversification and maintaining competitiveness by way of cost minimisation (Kerzner, 2019).
In Firm B’s consideration the major managerial factor decision that decided upon expansion of capacity includes the basis of motivation at the divisional level. Another consideration for managerial decision was to aim for increasing rate of market growth to meet strategic necessity to maintain dominant market position from potential new entrants (Ehrhardt, and Brigham, 2016). Thus, both the firm’s apart from undertaking capital budgeting process there have been other managerial considerations for the firms as well.
3. Conclusion
3.1 Findings
The current case study analysis on capital budgeting assignment on the two firms by using of capital budgeting decision making process along with managerial decisions enabled arriving at decision for the projects. In the decision criteria made for Firm A, there was used comparison based on direct costs and estimation of profit/loss statement. All components of fixed as well as variable costs was ascertained to arrive at the destination choice that would render most profitable site for relocation. Formal evaluation technique that was used for considering relocation of the factory was relative difference in costs between the locations. However, the management of the firm completely ignored the cost differentials on the basis of time value of money (Sullivan et al, 2015). Critical analysis of the technique reveals that for the purpose of relocation an appropriate capital budgeting decision by using an appropriate approach had not been undertaken. Inflation as well as any movements in exchange rate was also not considered in the project (Žižlavský, 2014, p 510). Moreover, the direction that was adopted by the firm to consider an investment decision was not committed to an appropriate evaluation exercise (Project Management Institute, 2017). There was lacking a decision-making approach that could reveal managers of the firm appropriate decision-making alternative, thus an optimal decision in capital budgeting process was not arrived at.
While evaluating the capital budgeting decision process for Firm B was using traditional value-based approach. In the second stage option the firm made use of IRR and Payback Period method for estimating feasibility of the project (Lane, and Rosewall, 2015, p ). Hence the firm totally ignored on the time value of money by not considering DCF approach to evaluate the project. The choices made for the project did not take into consideration any realistic approach for undertaking possible investments (Kerzner, 2017). The board finally adopted decision that was not in consistent with the findings of either IRR or PP, this reflects incapability of the board to undertake planned course of action in evaluation of its capital budgeting decision (Young, 2016).
3.2 Recommendations
In the case study considered to develop this capital budgeting assignment both the companies failed to recognise appropriate time value of money technique in understanding/ considering of the capital budgeting decision making process. While evaluating cost of a project, wither in relocation or in expansion, it is crucial that an approach to understand the benefit arising from the cost at current time period is essential to be evaluated. A project acceptance or rejection criteria needs to be based on such cost factor. As contrary to traditional approaches the DCF method offers unique proposition and solution to inform suitable decisions to be taken for a project. This approach has not been adopted in both the companies as undertaken in the case study hence failing to reject an inappropriate project or not accepting an optimised one. A suitable capital budgeting decision for a project can adopted by considering these cost factors when discounted at the current rate for making an informed decision which needs to be applied by these two firms.
4. References
Daunfeldt, S.O. and Hartwig, F., 2014. What determines the use of capital budgeting methods?: Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), pp.101-112.
Ehrhardt, M.C. and Brigham, E.F., 2016. Corporate finance: A focused approach.Capital budgeting assignmentCengage learning.
Fehrenbacher, D.D., Kaplan, S.E. and Moulang, C., 2020. The role of accountability in reducing the impact of affective reactions on capital budgeting decisions. Management Accounting Research, 47, p.100650.
Gilbert, E., 2005. Capital budgeting: A case study analysis of the role of formal evaluation techniques in the decision making process. SAJAR, 19(1), p. 1-13. DOI: 10.1080/10291954.2005.11435114 Horngren, C.T., Datar, S.M. and Rajan, M.V., 2015. Cost accounting: A managerial emphasis.
Kerzner, H., 2017. Project management: a systems approach to planning, scheduling, and controlling. John Wiley & Sons.
Kerzner, H., 2019. Using the project management maturity model: strategic planning for project management. John Wiley & Sons.
Lane, K. and Rosewall, T., 2015. Firms’ investment decisions and interest rates. RBA Bulletin, pp.1-7.
Project Management Institute, 2017. A Guide to the Project Management Body of Knowledge, PMBOX Guide, 6th Edition. Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International Journal of Management Practice, 8(1), pp.43-56.
Sullivan, W.G., Wicks, E. M., Koelling, C.P (2015). Engineering Economy. 16th Edition, USA: Pearson Higher Education
Young, T.L., 2016. Successful project management. Kogan Page Publishers.
Žižlavský, O., 2014. Net present value approach: method for economic assessment of innovation projects. Capital budgeting assignmentProcedia-Social and Behavioral Sciences, 156(26), pp.506-512.
