Write an essay outlining the impact of Capital Budgeting decisions on shareholders wealth maximization as well as the qualitative factors that affect Capital Budgeting process and decision.
Impact of Capital Budget and Qualitative Factors of Capital Budget on Shareholders Wealth
Impact of Capital Budgeting Decisions on Shareholders’ Wealth Maximization
Capital budgeting also known as investment appraisal is a decision-making and a design analysis tool that a company management applies to evaluate investments consistent so as to maximize the wealth of the shareholders. Some of the reasons why capital budget is used when a company wants to achieve some of the goals; expansion by acquisition of fixed assets and infrastructure like real estates, also when they want to make replacements like obsolete assets, update software, do preventing maintenance. Another reason for capital budgeting in modernization, this could be reconditioning, reconstruction and adaptation of new assets, capital budgeting is also used to meet other purposes like advertising, consulting services and new products among other things. Notably, capital budgeting is designed to make sure the company remains competitive and viable, therefore, there has been great impacts that it has had on the shareholders wealth maximization.
Several reasons for capital budgeting have been embraced thus, has brought great impacts on the company. For instance, companies have been able to measure how it’s economic and financial profitability on a project will be projected. This is because before a company gets to capital budgeting they carry survey and research on the project. Availability of Cash flow for the existing business from the new investment helps the company grow and thus the shareholders enjoy wealth maximization. As a result, it is almost impossible or businesses to lack cash flow since the executives ensure that a project is viable to invest. Another impact of capital budgeting is that it has made most businesses to be successful. This is because most companies ensure good business decisions are made to ensure the organization’s growth and cost (Atrill & McLaney, 2012).
Lack of proper minds to implement the capital budgeting for a company has made most of the businesses to suffer loss thus sucking the cash flow for the other business and could lead to the collapse of both if no drastic measure is taken. However, use proper skills helps the company realize payback period and calculate profit index thus minimizing the risk of the businesses going. As result, the existing company gets to expand even to more branches and even could get shareholders better dividends. Use of payback period technique causes harm to the sustainability project, thus could lead to the collapse of a business since it does not take care of the cash inflows after the payback period. Another impact of capital budgeting is when using most of the techniques, some external factors are discussed, nor the dynamic or the growth and collapse of the business. It gives constant profitability index (Goel, n.d.).
Consequently, capital budgeting promotes the existence of leasing than own policy resulting to leasing of capital assets, which is said to result to great capital expenditure. This is because in the short run leasing is said to be cheap but in the long it is expensive than owning, since the business spends more on leasing. Additionally, capital budgeting promoted the availability of mechanisms for assigning maintenance. As a result, there are more options for paying for maintenance, thus maintenance of capital stock (Megginson & Smart, 2005).
It is also noted that capital market deters innovation. This is because when some of the companies stop dominating the key market, the financial managers could impose strict measures on new capital expenditure. Hence, innovative processes and products cannot clear capital budgeting hurdles as the managers could have projected. As a result, the company drags behind technology and begin to lose market share, which could result in restructuring or company undergo business exit. When a company is undergoing a new process or investing a new product, it results to decrease of value of old products which is said to be cannibalizing. Capital budgeting is formulated to avoid cannibalization. Hence, the need to calculate the present value or internal pressure to avoid decrease of company and investment value to the investors, thus cannibalization helps in the survival and the success of the business. In essence, capital budgeting has helped to define the size and set of cash flows of company’s assets, which later generate flows that define value, viability and profitability to the shareholders wealth.
There are different qualitative factors that can be measured precisely in numerical terms. Qualitative factors are usually measured subjectively. The capital investments are those that are bought for profitable appreciation. They are influenced heavily by quantitative factors like expected return on investment and price. Managers have to consider different qualitative factors when deciding on capital investments. Safety, ethics, environmental concerns and company culture can affect decisions about whether or not to acquire capital resources. These qualitative factors when well understood help a firm to make informed capital investment decisions.
Capital investments influence how an organization performs its work. For example, adding a third office complex in a different town can change the flow of information and communication between different teams, or it might even affect reporting relationships. Another instance is when a business adds an automation system to its production line. This can completely change the team dynamics on the factory floor. Before a company makes a capital-investment decision, the manager needs to understand how the company’s culture will be affected by the additional resource, including the values of people, the way they work together and the general motivation and employees’ morale to succeed. Such considerations are expected to come about more heavily where productive physical resources are concerned as opposed to financial investments.
Capital investments impact the environment in various ways. The options that seem more affordable usually have bigger impacts as compared to options that are more expensive. Due to this fact, the quantitative factor of the price can be different from the qualitative factor affecting environmental responsibility. Managers need to take into consideration what impact any capital investments may have on their surrounding environment. For instance, when they purchase new trucks to be used for delivery, they should balance their intended price of purchase with the possible environmental impacts of the trucks. They should not just get trucks that pollute the environment simply because they are cheaper to acquire. However, they should consider getting the trucks that are as environmental friendly as they can afford. This way, the company will be preserving the good of the locality for years to come as opposed to only serving its own interests.
Ethical considerations are also very impactful when it comes to capital budgeting. These include different ethical areas such as the safety of employees, employment of locals and the air quality in the locality among other factors. Companies need to think heavily of these factors before purchasing new equipment or facilities, regardless of the intended profits or low cost of investment. When a production facility is overhauled to automate certain tasks, it will lead to a massive reduction of staff. This can be very cost effective and profitable for the company. It can also increase efficiency. However, it can lead to public animosity because many locals will have lost their jobs. On the other hand, installing fire protection systems that are of low quality can also endanger the lives and safety of employees. Therefore, companies need to always factor in these ethical issues whenever capital budgeting is in question.
Product quality is another major qualitative factor that impacts budgetary considerations. As much a company may want to increase its productivity, at no point should it look down upon the quality of its products. Therefore, any budget considerations of the company should ensure that the quality of the product is maintained. The only options where quality is concerned should either be to maintain the quality or to increase it, but never should it go down in the name of cutting costs or acquiring new machinery. Manufacturing flexibility should always be considered. Justifying new technology for manufacturing usually is very difficult. This is because most of its advantages are not easy to quantify. Traditional ways of capital budgeting usually rely on return measures, heavily dependent on an increase of profits and direct cost savings. However, manufacturing flexibility has great strategic benefits. These include faster responses to the needs of customers, an increase in product quality and the opening up of options for growth in future. Such also help to develop a good image of the company by the general public(Shapiro, 2005).
Companies that are huge and have big development and research budgets constantly try to develop new technologies. These may not benefit the companies immediately, and can even end up yielding fruit after many years. It is not easy to forecast whether or not they will pay back. A corporate culture that is dedicated to innovation should be thought of by companies. This culture brings about massive technological breakthroughs when properly implemented. For example, expenditure in Project 1 can bring about a resultant invention, Project 2, which may end up being more viable commercially than Project 1 which was initially funded. The management of the company will have had the courage to approve Project 1, even without clear and quantifiable benefits. However, this step will have brought about the great unforeseen benefits of Project 2. This shows that the company believed in the creativity of their staff (Bierman & Smidt, 2007)
A capital investment may be made on an asset that does not fit into the current goals of a company – purely for strategic reasons. For example, one may buy a piece of the land way before any plans are made to build on the property. This may be done for strategic reasons, such as to prevent an acquisition of the property by a competitor, given that there may be significant and continuous growth of traffic in the area which may one day make it an ideal location for a new branch. In this strategic measure, the immediate payback is the denial of the competitor from securing the prime location that could eventually boost its market share and revenues (Bierman & Smidt, 2007).
Budgetary considerations are also affected by the morale of their employees. There are companies that spend more money doing capital improvement so as to create a better environment for their employees to work in. For example, when a company purchases new furniture, it may not bring forth immediate and quantifiable monetary returns for the company. However it can increase the morale of the employee, therefore resulting in better productivity. The employees and the public view the company’s management as caring enough to ensure that they have a functional, comfortable and attractive place to work in. Good quality office environment also helps in bringing out a positive image to both the customers and the vendors who come to the office. If the environment in the office seems to be outdated and shabby, the image of the company may suffer to the extent that customers would even want to do business somewhere else.
Atrill, P., & McLaney, E. (2012). Accounting and finance for non-specialists. Harlow: Financial Times/Prentice Hall.
Bierman, H., & Smidt, S. (2007). Advanced capital budgeting. New York, N.Y.: Routledge.
Ebert, R., & Griffin, R. (2005). Business essentials. Upper Saddle River, NJ: Pearson Prentice Hall.
Epstein, M., & Rejc, A. (2014). Making sustainability work. San Francisco: Berrett-Koehler Publishers, Inc.
Goel, S. Capital budgeting.
Megginson, W., & Smart, S. (2005). Introduction to corporate finance. Southbank, Vic.: Thomson/South-Western.
Shapiro, A. (2005). Capital budgeting and investment analysis. Upper Saddle River, NJ: Pearson/Prentice Hall.