Capital Budgeting Practices: Journal Analysis and Comparison

This report provides an in-depth analysis of capital budgeting, a crucial aspect of financial management. It begins with an introduction to budgeting, its merits, and drawbacks, focusing on capital budgeting. The report then analyzes two journal articles: "Cost of Capital Estimation and Capital Budgeting practice in Australia" and "Improved Capital Budgeting Decision making: Evidence from Canada." The first journal examines capital budgeting practices in Australian companies, particularly the use of the Capital Asset Pricing Model (CAPM), and the second explores the evolution of capital budgeting decision-making in Canada. The analysis includes the purpose of each journal, research questions, methodologies, and findings, followed by a comparison of the similarities and differences between the two studies. The report highlights the significance of capital budgeting in financial planning, investment decisions, and overall organizational success, concluding with insights into the evolution and application of capital budgeting techniques across different geographical contexts.

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By student name
Professor
University
Date: 25 April 2018.
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Contents
Introduction.................................................................................................................................................3
Merits carried by Budgeting........................................................................................................................4
Drawbacks of the budgeting process...........................................................................................................5
Selection of the Journals to be discussed....................................................................................................5
Brief synopsis about the journal topics selected.....................................................................................6
Purpose of the journal and exploration of possible research questions..................................................6
Similarities in the two studies..................................................................................................................7
Differences observed in the two studies.................................................................................................8
Conclusion...................................................................................................................................................9
References.................................................................................................................................................10
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Introduction
Budget is a term associated with almost any economic activity that we perform in our day-to-
day lives. Its application can be seen in across all forms of routine time. In simpler terms budget
can be defined as an activity to monitor, plan and control. The thing to be monitored, planned
or controlled can be either time or money or any other resource that is not unlimited and
carries a value. Every company needs to have a proper budget based on which they can decide
what future course of action they need to take. There are many such areas in which the
company might have to struggle if proper budgeting is not done (Appelbaum, et al., 2018).
Budgeting helps in deciding what if there is any situation in which the management is stuck how
they will come out of it. The necessity of budget comes from not only from a control
perspective but also from a perspective of discipline. Without a definite course of action being
set on utilization of a limited resource there are chances of it might being under or over utilized
which could in turn deviate actual results of a task from the target. Now the question arises as
to how to determine a budget. This process involves a host of calculations that calls for
estimation and assumptions of certain costs and incomes that are to arise in the future periods.
Budget to some extent eliminates uncertainty and offers smoothness in terms of flow of funds.
Regardless of the nature of the organization, its size of operations, extent of availability of a
resource, it must plan and implement a budget to achieve desired results. There are various
categories of budgets that are involved that are widely used in the corporates. Some of them
include – Sales budget, capital budget, cash budget, project budget and revenue budget. In
addition, production budget. Sales budget is considers estimated the quantum of sales the
company is likely to have given the market conditions (Arnott, et al., 2017). Cash budget lists
out the relevant cash expenditures to be made during a period and the amount of cash the
entity expects to generate from various sources to have a picture of the cycle. Production
budget is being considered with the units to be produced during the year with given amount of
resources. Capital budget calculated the capital expenditures required taking into consideration
the present value of time. Project budget points out all the incomes and expenses that are or
will be related to a project during its operational phase. These various types of budget can be
presented annually, its frequency may be increased to quarterly, or monthly depending on the
requirements felt by the management as to if, it wants to have shorter period targets. There
are other classifications of budgets as well based on certain attributes it possesses. There
flexible budgets as well which are considered more realistic than static or fixed budgets.
Flexible budgets account for increase in prices of material and labour or other factors.
Management in some cases also sets performance budgets, which measure actual
performances during the year against planned levels of execution (Bromwich & Scapens, 2016).
One of the newer versions of budgeting is the Zero-based Budgeting, which is used when the
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resources are scarce and the entity feels that the pre-defined parameters of control are not
effective, and computation need to be analysed from the scratch. Out of the numerous types
of budgets discussed above, we will put our focus to Capital budget, which also the topic
discussed on the two journals. Along with it, we shall also have a walk-through of various
advantages and disadvantages budgeting possesses (Choy, 2018).
Merits carried by Budgeting
The process of budgeting carries a host of benefit if used in an appropriate manner. Few of
them are enlisted as under:
a) Financial goals are kept intact using budgeting. Unnecessary splurge of limited resource
can be curtailed so that this fund could be channelized towards rewarding avenues and
avoid a crunch in resources.
b) Through Budgeting, an organization can better organize its planned savings and
expenditure (both capital and revenue). They can have a clear view of how much of the
savings and quantity of the expenditure to be allocated to different categories. By using
budgeting, the organization is better positioned to deal any adjustments that might be
required to be made in each point of time (Calvasina & Calvasina, 2017).
c) With the use of budget, the organization can muscle its control over its resources. It can
monitor and authorize the flow of funds, which ensures that if there were any
deviations from the usual path, attention would immediately be drawn towards it. This
removes the possibility of any last moment shortage of funds.
d) Budgeting removes the primary level of uncertainty and answers several ‘How’s. For
instance, preparation of a cash budget will help the firm in knowing what are its
expected outflows and whether it will be have the required liquidity coming from the
inflows to meet the payments. If they do not have sufficient funds, they are being made
aware of it at a very early stage giving them the time to act accordingly (Tysiac, 2017).
e) Since the organizations can plan the movement of their resources, life would become
easier for the management when it comes to deciding the goal congruence objectives of
the company.
f) Budgeting helps in improving the performance of the management and employee of the
company and based on that they can decide if their functions are effective or not. If the
results are not as per the budget set they can take steps to find, where the loopholes
are and accordingly can function.
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Drawbacks of the budgeting process
Like any other method of management accounting, Budgeting too carries certain downsides
attached to it. Some of them are enlisted as under:
1) The planning for a budget involves extensive use of time, effort and people. There is
working involved in assimilation of data, its presentation and computation
requirements. This involves extra cost as well. In addition, the data prepared will need
to be verified by the people who are charged with the governance responsibilities of the
entity. There could be situation where the organization might not be able to stretch its
resources this much. Even if they do, there could be instances where their regular
operations are compromised because of this exercise (Delone & Mclean, 2004).
2) Through budgeting there are allocating of resources to various departments within an
entity, which at times will not be equal or proportional to their size. This has the
potential to create rift between departments and where it turns out that the allocations
are beneficial to one department more than the other is. There are possibilities of
allegation of bias being thrown. Since it is the duty of the management to perform these
allegations, it might become a very cumbersome task for them to pay more attention to
the judicious nature of the allocation (Erik & Jan, 2017).
3) There have been instances where there were inaccuracies observed in the calculations
done in a budgeting exercise. The whole exercise involves extensive use of estimation
and assumptions since budget is a way to forecast events. The parameters for this
estimations and assumptions are based on the market conditions at the time of study.
Since market conditions are generally volatile its highly likely that the standards set may
become unrealistic in a very short span of time thereby not achieving the objective
despite all the efforts in putting the budget map.
4) Sometimes the funds allocated in a budget may send a signal that is never intended the
way it is perceived. There could be situation where certain may not require all the funds
allocated to it. However, due to a fear of being reprimanded for spending less or being
allocated less resources in the coming years, the managers end up spending the
resources in a manner that may not be considered legible or may not be a wise choice.
This leads to wastage of resources (Fukukawa & Mock, 2011).
Selection of the Journals to be discussed
For discussing the certain attributes of budgeting in detail, we have shortlisted two journals.
In our assignment we have selected capital budgeting as a topic to discuss. The first journal
to be selected is written and documented by Giang Truong, Maurice Peat and Graham
Partington. The article is titled as “Cost of Capital Estimation and Capital Budgeting practice
in Australia” (Truong, et al., 2008). The second chosen topic in this assignment is articulated
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and authored by Karim Bennouna, Teresa Marchant and Geoffrey G. Meredith. The article is
titled “Improved Capital Budgeting Decision making: Evidence from Canada”.
Brief synopsis about the journal topics selected
The first journal focuses on the capital budgeting practices followed by listed Australian
entities. The second journal is inclined towards about the evolvement of the decision-
making process in Canada facilitated by capital management process. A detailed analysis is
presented under:
Purpose of the journal and exploration of possible research questions
The first journal focuses on the evolution of capital budgeting as a management analysis
tool in Australia and how capital asset pricing model, which is an integral part of this tool,
has been widely used in the country. Among the things highlighted are the adoption of real
option in place of discounting technique of cash flow, the differences in the practices and
treatment of corporate methodologies and regulatory framework, the inputs considered by
companies when using the CAPM model, etc. There were surveys done by MacMohan,
Hobbes and Lilleyman (Linden & Freeman, 2017). The survey highlighted the increasing
relevance of discounted cash flow techniques and the growing acceptance of Weighted
Average Cost of Capital as the discounting rate in computations involved in capital
budgeting. There were multiple surveys conducted to assess the spread of use of CAPM
model in many countries. A survey conducted by Kester in Australia as well as in the Asia
pacific region showed that an overwhelming 73 percent of the companies across the regions
surveyed had adopted to use the CAPM technique. The computation of tax credit was
another important aspect covered by the journal. For various purposes of evaluation, a total
of 488 firms were included in August 2004. It was called the ordinaries index and consisted
of only Australian companies as the emphasis was laid down on studying the practice of
capital budgeting in Australian entities. The surveyors were more inclined to take in large
companies for the survey as the chances of their participation was combatively higher when
compared to the smaller ones. The survey consisted of 20 questions. 24.4 % invitees
responded to the survey (Hall & Rapanotti, 2017). The cumulative revenue of the
respondent was pegged at 1.32 billion dollars. It was observed by the authors articulating
the surveys that that there were many companies which did not blindly relied on capital
budgeting techniques and rather cross checked the results by performing some other
computational techniques. Among them the NPV, Payback period method and Internal rate
of return techniques were also used. However, it was clear that the CAPM technique was
the most sought-after technique among others. There were 82 companies found to be users
of the NPV technique, which forms 94 percent of the entire population. A miniscule
percentage of respondents were found to be using other techniques. A host of tables and
charts presented in the journal analyse the above-mentioned techniques. It was observed
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that a few companies missed out adjustments related to dividend imputations, which was
very much required to be done.
Ongoing through the contents of the second journal we come across certain additional
facts. This journal is centred on the financial tools in the Canadian corporate space. The
report suggests that the Canadian firms are lagging when it comes to using advanced tools
like capital budgeting for the purposes of decision-making. It is being said that the last study
was perhaps conducted about 5 decades ago. Methods like discounting factor usage in
computing cash flows are not used (Bennouna, et al., 2010). Their study seems to point out
that the correct way of using discounted cash flow technique is also one area that needs
attention as it determines the how much effective the study would be as it was observed in
some of the instances that cash flows were not properly determined. Besides this, a few
other deviations were observed in the Canadian since. For instance, instead cash flows the
firms were found to be using accounting income. Inflation was being recognized in the
computation. In finding the weighted average cost of capital, the firms were found using
boom value of the debts and equity instead of the market values. Also, there was lack of
research in finding the weights as well. They were also found to be missing either debt or
equity in computing the cost of capital. It was observed that 17 out of 88 firms who were
part of the survey did not use the discounted cash flow technique. Therefore, the surveyors
had to restrict the participants to a few large corporate houses who were using the method
(Segal, 2017). The report issues certain advisories about the administration aspect of the
companies as well. The study revealed that in Canada, sensitivity analysis was a very
popular tool that was used. 92.8 % of the firms used it as against 85.3 % of users of scenario
analysis. Risk adjusted discount rate (RADR) was used in 76.8% of the participants.
Sensitivity analysis and RADR saw a significant rise in usage as compare to the last time a
research was conducted. It was also observed that a quite a few Canadian and American
companies find it difficult to segregate cost of capital division wise.
Similarities in the two studies
Following are the similarities observed between the two journals:
1. In both the journals, the discounted cash flow technique was touted to be the most
widely used Capital budgeting technique.
2. The authors of both the journals laid emphasis on the importance on the correct
knowledge and proper application of the capital budgeting technique to yield useful
results (Werner, 2017).
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Differences observed in the two studies
These differences were observed between the two journals:
1) The first study paper primarily dealt with how to estimate the cost of capital
appropriately. However, the core emphasis of the second study paper was focused on
enhanced tools used in capital budgeting technique.
2) The first study discussed upon the decision-making process about capital budgeting in
the Australian work environment whereas the other journal was more concerned about
the extent of improvement required in the use of capital budgeting techniques in
Canada and highlighting the current flaws (Schoenberger, 2016).
Overview of the relevant learnings from the research findings and the specific outcomes out
of it:
Below are the pertinent points to note observed during our review of the materials
contained in the first journal-?
a) The popularity of the real option as technique for evaluating projects is on the rise.
However, it is being used by the minor players of the industry and hence is not making a
significant impact.
b) The company do not blindly follow a single technique of capital budgeting. Apart from
the NPV method, other methods like the payback period and IRR also used for
evaluation purposes (Chron, 2017).
c) The companies have been founding using a static discount rate period after period
despite having the knowledge about the significance of variations through time.
d) Both in the Asia pacific region as well as in Australia, weighted average cost of capital is
being widely used for estimating cost of capital, CAPM is used extensively.
While reviewing the second journal, we came across several aspects that were critical
piece of information:
a) Limitations such as isolation of observations to one country was observed in this study
paper. The study has successfully highlighted the significance of capital investment. The
challenges that the entities face in the implementation of the discounted cash flow
technique are also brought under light in the paper (Dumay & Baard, 2017).
b) The technique of discounted cash flow has become almost synonymous to the capital
budgeting practice. This is actually because of the wide acceptability the technique
enjoys across industries. Though other techniques are used not very frequently adopted
or used in many organizations but it, there is no extinction of those methods. They are
still used in certain pockets of the industry.
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c) The wide usage and acceptability of the discounted cash flow method however does not
absolve itself from the fact that its correct application is still posing as a challenge. There
is an immense scope of improvement in which the organizations are supposed to apply
its principles. Until that happens, the desired benefit that should come with its use will
not follow. There is an urgent need to address these issues (Félix, 2017).
Conclusion
In the given assignment, based on the overall analysis it can be said that budgeting is an
important tool for the management of the company and they should try to use it as much as
they can. The two article highlights the different areas of budgeting which, as user is helpful;
they help in understanding how companies can improve their process of budgeting so that they
get the best result. Hence based on the overall analysis it can be said that budgeting should be
focused on long-term needs of the company and less on the short-term goals. Budgeting helps
the company in foresight the several issues that might crop up in the future. So overall, it helps
in improving the efficiency of the company in leaps and bounds and hence should be adopted.
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