WHAT IS CAPITAL BUDGETING ?

‘ A capital budgeting decision refers to the firm’s decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over the a series of years’ ( I.M Pandey 2010).From this , we note that capital budgeting refers to the assessment of investment decision or disinvestment decision so as to see if it is realistic or not. The investment is done in assets that generally affect the firm’s operation for beyond one year such as new/ replacement machinery, new plants, and research development projects, are worth pursuing. It is planning for main capital, investment or expenditures.

Any investment which adds to the shareholder’s wealth more than its cost will be acceptable, and here the opportunity cost of capital is the benchmark ; the investment will be acceptable if it brings more return the alternative of keeping the money in a bank and yielding back interest.

Capital budgeting decisions involve the following elements;

it should consider all the cash flows of the investment in determining the true profitability of the investment

it should provide an objective and and an unambiguous way of distinguishing the good projects from the bad projects

it should help to rank investment in order of profitability

it should recognize the fact that large and early cash flows are preferred

it should be applicable to any conceivable investment project.

There is a number of cash flow techniques that can be used to evaluate an investment. They range from discounted cash flows methods ( Net present Value, Internal rate of return, Profitability index) to non discounted cash flows methods ( Payback, Discounted payback, Accounting rate of return). It is to be noted that for the purpose of this assignment we will consider only the net present value.

There are some reasons that show the importance of Capital investment decisions :

i) The affect the firm’s growth in the long run,

ii) They affect the risk level of the firm,

iii) They involve the displacement of large funds,

iv) They are irreversible or reversible at a considerable loss

v) Because of the difficulty and stress that these decision carry.(Quirin, G.D., The capital Expenditure Decision, Richard D.Irwin, 1977).

Multinational Capital Budgeting.

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows and outflows associated with prospective long term investment projects. Multinational Capital Budgeting techniques are used in traditional FDI analysis, such as the construction of manufacturing plant in another country, as well as in the growing field of international mergers and acquisitions. Capital Budgeting for a foreign project uses the same theoretical framework as domestic capital budgeting — with a very few important differences. The basic steps are as follows:

• Identify the initial capital invested or put at risk

• Estimate cash flows to be derived from the project over time, including an estimate

of the terminal or salvage value of the investment.

• Identify the appropriate discount rate for determining the Present Value of the expected cash flows.

• Apply capital budgeting decision criteria such as NPV or IRR to determine the acceptability of the project.

Complexities of budgeting for a foreign project.

Capital Budgeting for a foreign project is considerably more complex than the domestic case. Several factors contribute to this greater complexity.

Parent Cash flows must be distinguished from project cash flows. Each of these two types of cash flows contributes to a different view of value.

The cash flows of a foreign project are in a foreign currency and hence subject to exchange risk from the point of view of the parent company.

Managers must evaluate political risk because political events can drastically reduce the value of expected cash flows.

Parent cash flows often depend on the form of financing. Thus, we can’t separate cash flows from financing decision.

The foreign country may impose withholding taxes on remittances like royalty, license fees, interest and dividend paid by a subsidiary to its overseas parent. In addition, the home country may also impose taxes on the parent company on the incomes it receives from its foreign subsidiary. If a double taxation avoidance treaty is in place, the parent may receive credit partial or total, for the taxes paid overseas.

The parent company may have some funds accumulated in a foreign country which cannot be repatriated or can be repatriated only after paying heavy penalty taxes. It may make sense to invest such block funds in a subsidiary or joint venture in the foreign country.

Managers must anticipate differing rates of national inflation which can affect differing cash flows

Terminal value is more difficult to estimate because potential purchasers have widely divergent views

Calculation Formula & Approaches of NPV

Although several capital budgeting techniques are available, a commonly used technique is to estimate the cash flows and salvage value to be received by the parent and compute the NPV of the project, as shown here:

Complexities of budgeting for a foreign project.

Capital Budgeting for a foreign project is considerably more complex than the domestic case. Several factors contribute to this greater complexity.

Parent Cash flows must be distinguished from project cash flows. Each of these two types of cash flows contributes to a different view of value.

The cash flows of a foreign project are in a foreign currency and hence subject to exchange risk from the point of view of the parent company.

Managers must evaluate political risk because political events can drastically reduce the value of expected cash flows.

Parent cash flows often depend on the form of financing. Thus, we can’t separate cash flows from financing decision.

The foreign country may impose withholding taxes on remittances like royalty, license fees, interest and dividend paid by a subsidiary to its overseas parent. In addition, the home country may also impose taxes on the parent company on the incomes it receives from its foreign subsidiary. If a double taxation avoidance treaty is in place, the parent may receive credit partial or total, for the taxes paid overseas.

The parent company may have some funds accumulated in a foreign country which cannot be repatriated or can be repatriated only after paying heavy penalty taxes. It may make sense to invest such block funds in a subsidiary or joint venture in the foreign country.

Managers must anticipate differing rates of national inflation which can affect differing cash flows

Terminal value is more difficult to estimate because potential purchasers have widely divergent views

http://www.duplichecker.com/

Calculation Formula & Approaches of NPV

Although several capital budgeting techniques are available, a commonly used technique is to estimate the cash flows and salvage value to be received by the parent and compute the NPV of the project, as shown here:

Complexities of budgeting for a foreign project.

Capital Budgeting for a foreign project is considerably more complex than the domestic case. Several factors contribute to this greater complexity.

Parent Cash flows must be distinguished from project cash flows. Each of these two types of cash flows contributes to a different view of value.

The cash flows of a foreign project are in a foreign currency and hence subject to exchange risk from the point of view of the parent company.

Managers must evaluate political risk because political events can drastically reduce the value of expected cash flows.

Parent cash flows often depend on the form of financing. Thus, we can’t separate cash flows from financing decision.

The foreign country may impose withholding taxes on remittances like royalty, license fees, interest and dividend paid by a subsidiary to its overseas parent. In addition, the home country may also impose taxes on the parent company on the incomes it receives from its foreign subsidiary. If a double taxation avoidance treaty is in place, the parent may receive credit partial or total, for the taxes paid overseas.

The parent company may have some funds accumulated in a foreign country which cannot be repatriated or can be repatriated only after paying heavy penalty taxes. It may make sense to invest such block funds in a subsidiary or joint venture in the foreign country.

Managers must anticipate differing rates of national inflation which can affect differing cash flows

Terminal value is more difficult to estimate because potential purchasers have widely divergent views

http://www.duplichecker.com/

Calculation Formula & Approaches of NPV

Although several capital budgeting techniques are available, a commonly used technique is to estimate the cash flows and salvage value to be received by the parent and compute the NPV of the project, as shown here:

Source: Essay UK - http://ntechno.pro/essays/finance/what-is-capital-budgeting/


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