“Capital budgeting over the years has become a sophisticated process for the finance officer. The different methods available to the finance officer have increased and become more accurate and centred upon the goal of maximizing wealth. However has there been an increase in the usage of these new methods or are decision makers still using the easier methods?”
Capital budgeting is a tool management use to make investment decisions. Despite the pitfalls pointed out in Yee-Ching Lilian Chan’s article “Use of capital budgeting techniques and an analytic approach to capital investment decisions in Canadian Municipal Governments”, which includes overemphasis on the quantifiable aspects of capital projects, random cut offs on the timing and the amount of cash flows, Unrealistic discount rates or IRR assumptions. Methods such as profitability index, internal rate of ...view middle of the document...
“In contrast to the traditional discounted cash flow analysis academics are beginning to talk about and some companies have incorporated real option analysis and economic value added metrics into their capital budgeting decision-making process” (Farragher, et all 2001)
Problems with the discounted cash flow models may have led some firms to go with the easier techniques. In “Capital budgeting models: theory vs. Practice” the results state that the payback period has high popularity even with the pointed out pitfalls that the model ignores the time value of money and secondly ignores cash flows received after the initial pay back period. Suggestions as to why it remains popular are that the technique is easy and simple to understand and calculate. The result the payback period technique gives is the amount of time it takes to recover the initial cost of a project, a breakeven point, and that amount of time is easily understood by the teams of people at each firm who have different training and backgrounds.
• Chan, Y. 2004, Use of Capital Budgeting Techniques and an Analytic Approach to Capital Investment Decisions in Canadian Municipal Governments., Public Budgeting and Finance, Summer 2004 pp 40 – 58
• Eljelly, A & Abuldris, A., 2001, A survey of Capital Budgeting techniques in the Public and Private Sectors of a less developed Country (LDC): The case of the Sudan, Journal of African Business, Vol. 2(1) 2001 pp 75 – 93
• Farragher, E., Klieman, R. & Sadu, A., 2001, The Association between the Use of Sophisticated Capital Budgeting practices and Corporate Performance. The Engineering Economist, Vol.46(4) 2001 pp 300-311
• Graham, J. & Harvey, C. 2001, The Theory and Practice of Corporate Finance evidence from the field. Journal of Financial Economics. Vol 60 2001 pp 187-243
• William D. Cooper & Robert G. Morgan & Alonzo Redman & Margart Smith. (2001). Capital budgeting models: theory vs. practice.. Available: http://www.entrepreneur.com/tradejournals/article/116186585.html. Last accessed 21 april 2010.