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ABSTRACT

The purpose of this study is to find the capital budgeting process which are used by large

firms and see the reality by getting the information from efficient

organizations. Capital budgeting is known as investment appraisal. There are required big

amount of funds for capital budgeting (Holmes, 1998). Once an investment proposal starts

there incurs a big cost on it and it is not possible to ignore this cost and the reversal of project

is also difficult (Holmes, 1998). Opportunities of investment that can produce or give benefit

for more than one year are called capital investments (Peterson &Fabozzi, 2002) On the basis

of normative contingency theory a model is structured and the aim for this model structuring

is to reconcile the results of some capital budgeting behavioral organizational studies with

financial theory. For reflecting the contingent model basic steps, this paper has four sections.

In first section paper describe about the capital budgeting process, in second there are

definitions of endogenous variables, i.e. variables that defines configuration of process and

those variables are internal structural variables; in third section about the exogenous variables

or contingent variables and these are external variables that influence the capital budgeting

process; in the last examine how capital budgeting process should be formatted and

structured and give values to external variables i.e. relationships between the internal with

external parameters. In this paper take the organizations and what are the capital budgeting

processes that are used in these organizations

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INTRODUCTION

Over the many years attention on Capital budgeting has increased very much. In a lot of

studies the attention has given on the relationship between financial theory and investment

decisions and also on behavioral aspect of capital budgeting. Today there have a lot of

critique on aspect of capital budgeting like separation between analytical and on

organizational behavioral. There are a lot of methods like strategic options, analytical

hierarchy process (AHP), Discounted cash flow methods; these methods cannot led to the

branch of organization and cannot supports the investment proposals. There are decision

making tools like investment evaluation techniques. These gives current organizations to

modify opportunities by give and spread information about the performance of new and

advanced technologies, adopting the cross functional analysis procedures, allow the

organizations to conduct post audit and all these supports the organizational learning. In this

paper there will also describe to how a lot of studies about the capital budgeting are based or

depend upon the financial theory and also how with the passage of time the development

sophisticated methods of capital budgeting have gained popularity. The process of analyzing

the investment proposal will be also determined. It also develops a conceptual framework

about the capital budgeting, its techniques or evaluation methods and also about the capital

budgeting decision making process. The importance will be given to problem which

integrates the linkages between the strategic planning process and the capital investment

coordination. This model will be depends and structured upon contingency theory principles.

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The Structure of the Capital Budgeting Process

Strategic Planning Process

Identification of investment
opportunities

Development

Evaluation

Selection

Authorisation

Implementation and Control

Post - Auditing

Structure of Capital Budgeting Process

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There are six stages of capital budgeting process that are identified. (a)identification of

investment opportunities,(b)development and evaluation, (c)Implementation and control,

(d)selection, (e)authorization,(f)implementing and control, (g)Post-auditing (Seitz & Ellison,

2005).

Identification of Investment Opportunities

This is very much important stage but its formulation is very much difficult. Because it is

very difficult to check the investment opportunity which will give you profit and which

investment proposal will be more benefited for organization. The organizations will see time

periods for investments and also see the funds which are available for investments.

Development and Evaluation

The identification of investment proposal is very much difficult and time taking task but

when identification of investment has completed then it is very much necessary to analyze

them completely; then collecting all the relevant information about alternatives, attractiveness

that are globally and also evaluate the profitability of the investment proposal.

Selection

Selection stage is also very much important for organizations because after identification and

after the development and evaluation there are a lot of reasons for selecting the investment

proposals because some proposal can be rejected due to time period and some can be

postponed for some future time period on that span of time it is very difficult to conduct that

project.

Authorization

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There are proper authorities or personals in organization which will approve the project then

the project can be conducted. If these investment committees or management approves the

proposal then implementation can be started.

Implementation and Control

Proper control is necessary for implementing the proposal because there are incurring budget

costs and there are necessary to meet the deadline which has already determined for the

proposal.

Post-Auditing

In this stage, comparison is made between the project and budget targets because to forecast

accuracy of the outcomes. And in this stage feedback is given in all the decision making

process. The first four stages are called heart of decision making process and last two stages

are taken due to their feedback effect.

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In figure it can be seen that most of the work in capital budgeting decision making process is

done in the strategic planning process. Link between the capital budgeting process and

strategic planning can be seen only in the companies because it cannot be seen in literature.

All the investments can be identified in the budgeting stage of strategic planning process.

This approach is based on the concept of investment modularity. Capital budgeting decisions

can be split into many smaller projects because capital budgeting processes are huge amount

of investments called Meta investments. The first three stages called the Meta investment and

the remaining three stages called the operational investments. But operational investments

stages are also starts from the identification stage.

Internal Variables

The second stage is about the identification and definitions of endogenous variables. These

variables represent that tools which management can use to make a suitable capital budgeting

process. There are identified two classes of variables i.e. first includes that variables which

represent organizational parameters and the methodological tools of variables. The problem is

to determine the degree of both who should be involved (lateral) and kind of coordination

among the systems (vertical). By decentralization of some activities the problem can be

solve. Second, variables consist of capital budgeting process supporting analytical tool. It is

important because it plays a key role in selection and also in valuation stage.

Contingent Variable

It is very insubstantial task to identifying the contingent variables. All the interrelationships

between capital budgeting process and other procedures of an organization system, external

factors and also their complexity are very important task. These variables are classified into

environmental, firm-specific and the investment specific variables. Environmental variables

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are considered as economic financial hostility, firm specific variables which include systems

which regulate the capital budgeting process and functioning of organization

The main Links between the contingent variables and the capital
budgeting process

Strategic Planning
Process

Structure (Formal
Strategy Organisation)
Capital Budgeting
process

Information System Control/ Evaluation/

Rewarding System

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The relationships between above variables and capital budgeting process are of two kinds.

Making of a formal organization, according to capital budgeting process requirements is not

suitable or is not feasible. To improve the efficiency of capital budgeting process,

information and control or performance measurement or rewarding systems can be adapted.

And these systems can be seen as global effectiveness of capital budgeting process. Third,

variable deals with each investment characteristics.

On the basis of objectives, investments can be divided into; compulsory investments;

investment in existing business era; investment in new business era; acquisition and for

research and development purposes.

Contingent Approach

In this stage the relationships between exogenous (external) and endogenous (internal)

variables examined.

The Identification phase

This stage plays an important and major role and due to this stage the global quality and

effectiveness of capital budgeting process can be determined. The complexity of this stage

can be determined by a number of contingent variables which includes environmental

variables, firm variables and also the investment specific variables. If organizational

environment is uncertain then there should be decentralization in its activities. Because in

dynamic or uncertain environment it is necessary to involve the lower level of management in

the planning process because then this process can be conducted more efficiently.

Capital budgeting is the planning of long-term corporate financial projects relating to

investments funded through and affecting the firm's capital structure. Management must

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allocate the firm's limited resources between competing opportunities (projects), which is one

of the main focuses of capital budgeting. [2] Capital budgeting is also concerned with the

setting of criteria about which projects should receive investment funding to increase the

value of the firm, and whether to finance that investment with equity or debt capital.

Investments should be made on the basis of value-added to the future of the corporation.

Capital budgeting projects may include a wide variety of different types of investments,

including but not limited to, expansion policies, or mergers and acquisitions. When no such

value can be added through the capital budgeting process and excess cash surplus exists and

is not needed, then management is expected to pay out some or all of those surplus earnings

in the form of cash dividends or to repurchase the company's stock through a share buyback

program.

Choosing between capital budgeting projects may be based upon several inter-related criteria.

(1) Corporate management seeks to maximize the value of the firm by investing in projects

which yield a positive net present value when valued using an appropriate discount rate in

consideration of risk. (2) These projects must also be financed appropriately. (3) If no

positive NPV projects exist and excess cash surplus is not needed to the firm, then financial

theory suggests that management should return some or all of the excess cash to shareholders

(i.e., distribution via dividends).

Capital budgeting involves allocating the firm's capital resources between competing project

and investments. Each potential project's value should be estimated using a discounted cash

flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance

by Joel Dean in 1951.) This valuation requires estimating the size and timing of all the

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incremental cash flows from the project. (These future cash highest NPV(GE).) The NPV is

greatly affected by the discount rate, so selecting the proper ratesometimes called the

hurdle rateis critical to making the right decision. The hurdle rate is the Minimum

acceptable rate of return on an investment. This should reflect the riskiness of the investment,

typically measured by the volatility of cash flows, and must take into account the financing

mix. Managers may use models such as the CAPM or the APT to estimate a discount rate

appropriate for each particular project, and use the weighted average cost of capital (WACC)

to reflect the financing mix selected. A common practice in choosing a discount rate for a

project is to apply a WACC that applies to the entire firm, but a higher discount rate may be

more appropriate when a project's risk is higher than the risk of the firm as a whole.

Ideally, businesses should pursue all projects and opportunities that enhance shareholder

value. However, because the amount of capital available at any given time for new projects is

limited, management needs to use capital budgeting techniques to determine which projects

will yield the most return over an applicable period of time.

Popular methods of capital budgeting include net present value (NPV), internal rate of return

(IRR), discounted cash flow (DCF) and payback period.

Capital budgeting is a step by step process that businesses use to determine the merits of an

investment project. The decision of whether to accept or deny an investment project as part of

a company's growth initiatives, involves determining the investment rate of return that such a

project will generate. However, what rate of return is deemed acceptable or unacceptable is

influenced by other factors that are specific to the company as well as the project. For

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example, a social or charitable project is often not approved based on rate of return, but more

on the desire of a business to foster goodwill and contribute back to its community.

Capital budgeting is important because it creates accountability and measurability. Any

business that seeks to invest its resources in a project, without understanding the risks and

returns involved, would be held as irresponsible by its owners or shareholders. Furthermore,

if a business has no way of measuring the effectiveness of its investment decisions, chances

are that the business will have little chance of surviving in the competitive marketplace.

Businesses (aside from non-profits) exist to earn profits. The capital budgeting process is a

measurable way for businesses to determine the long-term economic and financial

profitability of any investment project.

Capital budgeting is also vital to a business because it creates a structured step by step

process that enables a company to:

Develop and formulate long-term strategic goals the ability to set long-term goals is

essential to the growth and prosperity of any business. The ability to appraise/value

investment projects via capital budgeting creates a framework for businesses to plan out

future long-term direction.

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Seek out new investment projects knowing how to evaluate investment projects gives a

business the model to seek and evaluate new projects, an important function for all businesses

as they seek to compete and profit in their industry.

Estimate and forecast future cash flows future cash flows are what create value for

businesses overtime. Capital budgeting enables executives to take a potential project and

estimate its future cash flows, which then helps determine if such a project should be

accepted.

Facilitate the transfer of information from the time that a project starts off as an idea to the

time it is accepted or rejected, numerous decisions have to be made at various levels of

authority. The capital budgeting process facilitates the transfer of information to the

appropriate decision makers within a company.

Monitoring and Control of Expenditures by definition a budget carefully identifies the

necessary expenditures and R&D required for an investment project. Since a good project can

turn bad if expenditures aren't carefully controlled or monitored, this step is a crucial benefit

of the capital budgeting process.

Creation of Decision when a capital budgeting process is in place, a company is then able to

create a set of decision rules that can categorize which projects are acceptable and which

projects are unacceptable. The result is a more efficiently run business that is better equipped

to quickly ascertain whether or not to proceed further with a project or shut it down early in

the process, thereby saving a company both time and money.

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Unlike other business decisions that involve a singular aspect of a business, a capital

budgeting decision involves two important decisions at once: a financial decision and an

investment decision. By taking on a project, the business has agreed to make a financial

commitment to a project, and that involves its own set of risks. Projects can run into delays,

cost overruns and regulatory restrictions that can all delay or increase the projected cost of

the project.

In addition to a financial decision, a company is also making an investment in its future

direction and growth that will likely have an influence on future projects that the company

considers and evaluates. So to make a capital investment decision only from the perspective

of either a financial or investment decisions can pose serious limitations on the success of the

project.

In December 2009 ExxonMobil, the world's largest oil company, announced that it was

acquiring XTO Resources, one of the largest natural gas companies in the U.S. for $41

billion. That acquisition was a capital budgeting decision, one in which ExxonMobil made a

huge financial commitment. But in addition, ExxonMobil was making a significant

investment decision in natural gas and essentially positioning the company to also focus on

growth opportunities in the natural gas arena. That acquisition alone will have a profound

effect on future projects that ExxonMobil considers and evaluates for many years to come.

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The significance of these dual decisions is profound for companies. Executives have been

known to lose jobs over poor investment decisions. One can say that running a business is

nothing more than a constant exercise in capital budgeting decisions. Understanding that both

a financial and investment decision is being made is paramount to making successful capital

investment decisions.

In sum, the capital budgeting process is the tool by which a company administers its

investment opportunities in additional fixed assets by evaluating the cash inflows and

outflows of such opportunities. Once such opportunities have been identified or selected,

management is then tasked with evaluating whether or not the project is desirable.

Depending on the business, the competitive environment and industry forces, companies will

certainly have some unique desirability criteria. As noted earlier, it's very crucial to

remember that the capital budgeting process involves two sets of decisions, investment

decisions and financial decisions; given the unique business and market environments that

exist at the time, each decision may not initially be seen as worthwhile individually, but could

be worthwhile if both were to be undertaken.

Consider an example involving the coffee chain Starbucks. On Nov. 14, 2012, Starbucks

announced its intent to acquire Teavana, a high-end specialty retailer of tea, for $620 million.

The offer price for Teavana represented a 50% premium over the then market value of

Teavana. Based on the acquisition price, Starbucks would paying over 36 times earnings for

Teavana. Looking at this capital investment today, one can suggest that the financial decision

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paying $620 million for a company that generated $167 and $18 million in sales and profits

in 2011 was not a desirable one for Starbucks.

On the other hand, from an investment perspective, Starbucks is paying $620 million for

ownership of a fast-growing, leading tea retailer. Teavana gives Starbucks direct access to the

fast-growing underpenetrated tea market. In addition, Teavana instantly gives Starbucks

approximately 200 high-traffic retail locations and, more importantly, a very visible, high-

quality tea brand to complement its coffee offerings. Had Starbucks merely evaluated

Teavana from a purely financial perspective, the decision would have ignored that highly-

valuable benefit of combining the most well-known coffee brand with the highest-quality tea

brand.

Factors Influencing Capital Budgeting

1. Availability of funds

2. Structure of capital

3. Taxation Policy

4. Government Policy

5. Lending Policies of Financial Institutions

6. Immediate need of the Project

7. Earnings

8. Capital Return

9. Economic Value of the Project

10. Working Capital

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11. Accounting Practice

12. Trend of Earning

13. Size of Business

14. Risk of the business

15. Forecast of the market

16. Political unrest

17. Geographical Condition

18. Exchange Rate of Currency

The internal rate of return (IRR) is defined as the discount rate that gives a net present value

(NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually

exclusive) projects in an unconstrained environment, in the usual cases where a negative cash

flow occurs at the start of the project, followed by all positive cash flows. In most realistic

cases, all independent projects that have an IRR higher than the hurdle rate should be

accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project

with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The

IRR exists and is unique if one or more years of net investment (negative cash flow) are

followed by years of net revenues. But if the signs of the cash flows change more than once,

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there may be several IRRs. The IRR equation generally cannot be solved analytically but

only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the

actual annual profitability of an investment. However, this is not the case because

intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the

actual rate of return is almost certainly going to be lower. Accordingly, a measure called

Modified Internal Rate of Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR

over NPV[citation needed], although they should be used in concert. In a budget-constrained

environment, efficiency measures should be used to maximize the overall NPV of the firm.

Some managers find it intuitively more appealing to evaluate investments in terms of

percentage rates of return than dollars of NPV.

Need For Capital Budgeting

As large sum of money is involved which influences the profitability of the firm making

capital budgeting an important task.

Long term investment once made can not be reversed without significance loss of invested

capital. The investment becomes sunk and mistakes, rather than being readily rectified,must

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often be borne until the firm can be withdrawn through depreciation charges or liquidation. It

influences the whole conduct of the business for the years to come.

Investment decision are the base on which the profit will be earned and probably measured

through the return on the capital. A proper mix of capital investment is quite important to

ensure adequate rate of return on investment, calling for the need of capital budgeting.

The implication of long term investment decisions are more extensive than those of short run

decisions because of time factor involved, capital budgeting decisions are subject to the

higher degree of risk and uncertainty than short run decision.[3]

Top level management must avoid any interference in that type of organizations in which

there are high decentralizations. In a lot of cases the authorization process of capital

budgeting stage is the only one stage which is not included in the strategic planning process,

taking place just before the implementation of each project. There are a lot of purposes of this

stage i.e. to check attractiveness of investments, possible changes reflection in the

competitive context, up-to-date forecasts, or in macro-economic; and availability of budgeted

resources and their verification, since it might be reduced by negative variances of other

implemented.

Since analytical tools are not relevant in this stage, the analysis will focus on organizational

aspects: the fundamental issues consist in identifying who must be involved in the discussion

of investment proposals, and who holds final decision power.

There are following external variables that forced a vital influence on the authorization

process and this Includes: investment-specific variables; firms strategy; the strategic

planning process adopted by the firm.

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