Importance of Budgeting and Investment Decisions

An organization is based on the decisions made by its management. Therefore, decision making
process turns out to be a crucial part of an entity as one wrong decision could result in heavy
losses to the firm whether in terms of revenue or reputation. 'Decision - making involves the
examination of various courses of actions and choosing the most appropriate option in order to
arrive at a conclusion for a given scenario. Decision making process focuses on' goals'. It is
continuous in nature as our business environment is dynamic so as soon as one problem ends, the
other one arises and it goes on (Berman, Knight and Case, n.d.).
Corporate decision making takes place at various levels of the entity whether top down or bottom
up. Corporate decision making is characterized by its implementers because a decision is
effective only when it is being implemented in the best possible manner. The large laid plans can
go in vain if there is no commitment from the middle & lower management. Hence, it is
important for a management to maintain a good & healthy relation with its middle level & lower
level management (Bruner, Eades and Schill, 2017). Thus, corporate decisions are successful as
long as there is a 'glue' to keep the organization together in the form of encouraged leaders and
the firm that values coherence & maintains stability otherwise the entity falls into its own trap
leading to loss of competitiveness in the market.
Capital budgeting refers to the evaluation of the huge amount of expenditures and investments.
These expenses or investments include projects such as building a new plant or long term
investments (TULSIAN, 2016). Through capital budgeting, it becomes easier to evaluate
whether the returns provided by the company are meeting up with the targets, this is done by
calculating the lifetime outflows and inflows. This canalso be named as “investment appraisal”.
For a business, it is advantageous for it to take up all opportunities and projects but due a
Limitation of the availability of capital at a particular point of time, management uses capital
budgeting techniques to determine the maximum return from all the available projects at a time
(Clarke and Clarke, 1990). There are huge number of methods involved under capital
budgeting, they are explained below:
 DCF Analysis: The NPV concept and the DCF concept is similar to each other. In both
the case the initial cost, maintenance cost and the other cash outflows and inflows are
pulled back in order to compute the Net present value of the project.
 NPV: The amount of cash inflows over the cash outflows is known as Net present value.
It is used in the process of decision making through capital budgeting to determine the
profitability from a project or a long term investment. The positive NPV of a project is an
indication that the projected earnings exceed the costs while a negative NPV results in a
loss (Fairhurst, 2015). For example- There are two projects A and B having
different structures of cash flow and the required rate of return is 10.25
percent then the NPV of the cash flows will be as follows:

 Discounted Payback Period: This is a capital budgeting technique that determines the
period required to break even from undertaking an initial expenditure by pulling the
future value to the present value on practising time value of money. The rule says that the
projects with discounted payback period less than the targeted period are to be accepted.
 IRR : IRR is defined as the interest rate at which the NPV of all the cash flows id zero in
a given project or investment. This is used to evaluate the attractiveness of an investment.
The rule says that the project is acceptable if the required return of the investor is less
when compared to the IRR. However if the required rate is more than IRR then the
project is not acceptable by the investor (Taylor, 2008). From the same example that
has been taken for NPV we are calculating IRR:
Calculation of Internal Rate of Return of each project
For Project A:
For Calculation of IRR, Inflow=Outflow
Let be IRR 20.70% then
PV of Inflows
Year Cash Flow Present Value of Cash Flows
1 17000 14,085
2 17000 11,669
3 17000 9,668
4 17000 8,010
5 17000 6,636
50,067
Therefore, at 20.70% Pv of Inflows = PV of Outflows (50,000). Hence IRR is 20.70%
For Project B:
For Calculation of IRR, Inflow=Outflow
Let be IRR 14.70% then
PV of Inflows
Year Cash Flow Present Value of Cash Flows
1

- -
2 - -
3 - -
4 - -
5 99500 50,119
NPV 50,119
Therefore, at 14.70% Pv of Inflows = PV of Outflows (50,000). Hence IRR is 14.70%
Importance of Capital budgeting techniques is:
 Evaluation of Risks: long term investments are capital expenditures that involves
identifiable and significant financial risks. Therefore, for proper planning, capital
budgeting is important (Galbraith, Downey and Kates, 2002).
 Choosing of the best course of action: It helps a company to choose the best investment
project that would give the best possible returns after considering every possible course
of action available. It focuses on increasing the shareholders wealth and helps a company
in achieving an edge in the market.
 Irreversible Investments: the funds are limited but involve huge investments. Therefore it
is better to analyze the every possible scenario before investment as once a decision is
being taken or once the money is being invested; there is no option of reversing back the
decision.
 Long run of the business: capital budgeting helps in reduction of costs as well as
determination of best maximum profit of the company. Since it helps in avoiding the over
or under investments, proper planning & analysis through capital budgeting helps in
sustainability of the business in the ling run (Shim and Siegel, 2008).
Various capital budgeting techniques includes:
 Sensitivity Analysis: This is an analysis of determining the result of a decision using
different range of variables. The analyst determines the changes in dependent
variables due to different values of independent variables assuming certain conditions
to be constant. Its other name is what if analysis. Analysis could be made for any type
of decisions be it a family vacation or corporate level decisions. Its basic meaning is