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Benefits and costs of such a system to smaller businesses (SMEs)
The financial management of an organization has a very important characteristic that is capital budgeting of the firm. The capital budgeting of an organization is very important because capital assets are long term and the budgeting process should be very carefully handled as the company has to experience it for longer time. The capital budget has minimum of five years of duration. The basic reason of the long duration is the planning involved and the expectations with capital budgeting.
The overall fraction of capital assets is smaller as compared to the current assets of the company. Capital expenditure benefits an organization for longer then a year and capital budgeting is used to generate and evaluate capital expenditure. (Dr. Sharron Garrison, 2005). Dr Sharron explains in his research that in capital budgeting cash flows are more important as they are called as net investment which in end of year named as net cash flows and in evaluating, discount cash flow to present value are identified and the techniques are basically used to analyze real assets not the financial assets.
The knowledge about capital budgeting is very important for company managers or even CEOs because it impacts the whole company’s future prospects. There should be timed decisions on capital budgeting because there are very large investments so it can cause bad results with loss of quality assets and money. The capital budgeting is made for the needs of the company for future usage for example introduction of a new product in market that is required by customers and can benefit a lot better then other products are giving. The assets are generated in future and the capital budgeting for those assets that are measured in after tax cash flow.
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The calculation of the assets is always with the present value not the future so the estimation can be incorrect because the values in future cannot be predicted accurately. The capital budgeting is long term and taking the present value of an asset and estimating it as future value is risky. After the evaluating the asset as future value depends on the acceptance of the project. The usage of cash flows should always be after tax because cash used in paying taxes of projects.
The best return is if the funds are not invested as capital cost in projects such as opportunity costs of company which can be done by using already owned asset in different shape. The cost of the asset can be opportunity cost for the company. The induction of assets for the projects is also a part of budgeting process because it includes the cost that will be used in future usage of the asset. (Marc Ross. 1986) Marc Ross in 1986 studied the different methods of capital budgeting and done analysis on few large companies to do fine research on discounted cash flow methods. The research found that many companies use DCF methods especially “Internal rate of return (IRR)”.
While examining the capital budgeting for a company there are always different kinds of risks related to the capital expenditures because capital budgeting is long term. The analysis in term of risk is also very important for evaluating capital budgeting. The proper required rate of return is calculated to compute the project’s net present value.
The estimation of capital budgeting on wholly owned subsidiary is done by evaluating rate of return on equity and then adjusted in interest rate. There must be risk adjusted cost of equity is derived in such a way that it remains with the purpose of value maximization in capital budgeting.
Capital budgeting in smaller firms
Small firms are playing very important role in business world. A very important part of agriculture, manufacturing, construction and transportation industries are included in these small firms. The proper cost and budgeting is very important for such firms. The large firms usually use DCF methods to evaluate capital budgeting while the smaller firms usually use payback method. Very few small firms are using DCF methods. (Morris G. Danielson, 2005) and there are few (30 approx) many small which do not calculate any cash flows or evaluate any capital budgeting before the investment.
Small firms usually don’t have experts who can evaluate DCF methods for capital budgeting. Small firms do not participate in perfect capital markets because of the unavailability of proper operating sources and lack of account and finance staff that makes difficult for them to calculate cash flows. The payback method for evaluation is good for small firms because the managers of the firms find it easy to calculate and implement their decisions on it.
