Capital budgeting refers to a process of decision-making by businesses regarding long-term resource allocation. It involves evaluating new projects and investments by analyzing the inflows and outflows of cash and estimating the expected return. Capital budgeting revolves around the concept of time value for money (Menifield, 2021). A decision needs to be made whether the capital invested now is worth more than the future cash flow value produced by the investment.
The accuracy of the cash flows projected constitutes a foundation for efficient investment appraisal. Various methods of capital budgeting are available, such as payback period (PB), net present value (NPV), internal rate of return (IRR), profitability index, and others (Menifield, 2021). This section discusses how capital budgeting can be implemented in Byron Manufacturing and provides an example of a decision made using the IRR method of analysis.
For Byron Manufacturing, I would implement a six-step process of capital budgeting. To begin with, the long-term goals of the company must be determined. Then, investment opportunities and potential proposals must be identified in accordance with the goals set. The next step involves estimating and analyzing the relevant cash flows of all the investment proposals identified. The financial feasibility of the proposals must be determined through the capital budgeting methods of analysis.
Then, projects identified as economically feasible and relevant must be implemented. Finally, the review of performance and monitoring must be conducted to evaluate how the capital budgeting projections are met and make improvements if needed. Overall, such an approach would allow Byron Manufacturing to collect and assess numerous investment proposals while choosing the most profitable one.
An example of a decision made by analyzing the financial feasibility of capital investment would be choosing between two projects with the same initial investment. For instance, Byron Manufacturing considers investing in new software for controlling the manufacturing processes or replacing the old machinery. Byron Manufacturing seeks to know which option is more desirable to choose based on the company’s cost of capital.
The IRR method will be applied since it considers time value for money. It is expressed in percentage terms and considered an efficient tool for comparing and selecting the most worthwhile opportunity. For the first project, buying new software, the expected initial investment is $50,000 in the first year, followed by incoming cash flows of $30,000, $42,000, and $45,000 in the next three years. For the second project, purchasing new machinery, the expected initial investment is $50,000 in the first year, followed by incoming cash flows of $25,000, $30,000, and $45,000 in the next three years. As shown in Table 1, the IRR for buying new software will be 53%, while the IRR for replacing the old machinery will be 39%. Hence, the first project would be chosen since it has a higher internal rate of return with the same initial cash investment for the beginning period.
Table 1. The internal Rate of Return Analysis.
Note. Two investment projects are analyzed for Byron Manufacturing using the IRR method.
Overall, capital budgeting is a complex process that has a pivotal role for companies planning investments. Combining various analysis tools is recommended to make an efficient capital budgeting decision. The IRR method was chosen for Byron Manufacturing since it allows for comparing potential rates of annual return over time. Based on the analysis, the first project involving new software purchase was chosen as preferable since it has a higher IRR.
Reference
Menifield, C. E. (2021). The basics of public budgeting and financial management: A handbook for academics and practitioners. Hamilton Books.