Public companies owe a fiduciary responsibility to the shareholders that specifically involves wealth maximization. The responsibility is critical in guiding decision-making in companies, especially in project selection. Capital budgeting techniques are applied in evaluating and planning significant company investments or expenditures. Therefore, public companies consider capital budgeting decisions a critical part of financial planning. The companies must keenly evaluate the potential risks and rewards of different investment options to determine the most viable and profitable undertaking. The management must make informed decisions that align with their overall business strategy. In the process, public companies have to consider several factors, such as regulations, market conditions, and competition. There are several methods that public companies can apply in the capital budgeting process, including the net present value (NPV), internal rate of return (IRR), payback period, and return on investment (ROI). Publicly listed companies often prefer to use the NPV method as it is multifaceted, unbiased, objective, and widely accepted by regulatory bodies.
The net present value (NPV) is a sophisticated, discounted capital budgeting technique. The method considers the time value of money, risk-adjusted net cash flows, and inflation. The first step in finding the NPV involves computing the present value of cash inflows and subtracting the initial investment required for a project (Mollah et al., 2021). The cash flows are a component of the steps involved in the capital budgeting process. The steps include specifying project proposals, evaluating cash flows, assessing projects, choosing the projects, executing projects, and conducting a post-completion audit. The resultant NPV represents the excess or deficit of a project’s cash flows compared to the initial capital investment. The value obtained then informs the subsequent processes of project selection as it defines which project among competing alternatives needs to be implemented or if the planned investment is not viable.
Effective capital budgeting decision-making needs a more multifaceted technique. According to Mollah et al. (2021), NPV is a discounted method that considers the time value of money. Public companies prefer the method because it appreciates that money received in the future is worth less than its current value. The NPV calculation involves discounted future cash flows primarily calculated using the weighted average cost of capital (WACC). Therefore, the NPV method accounts for the reality that money has a diminishing value over time. The multifaceted approach makes the NPV method more accurate and comprehensive in evaluating a project’s profitability compared to the techniques that do not consider the time value of money, such as the internal rate of return (IRR) or the payback period.
The preference for the NPV approach is informed by its being objective and unbiased. Mollah et al. (2021) confirmed that over 71 percent of the chief financial officers in public companies used NPV as the primary method for capital budgeting decisions. The preference is widely attributed to the NPV’s establishment of a clear set of rules and computations that can be applied invariably to any project, notwithstanding its size or complexity. Public companies find it easy to use the NPV to compare the relative merits of different projects and make informed decisions about which ones to go after. In the increasingly regulated operating environment, public companies prefer the NPV method, which is widely accepted and recognized by financial professionals, regulators, and investors. The NPV method is a standard tool in capital budgeting decision-making taught in business schools worldwide. The companies use the NPV method to demonstrate to stakeholders that they are using a reputable and respected method for evaluating investment opportunities.
Like any other tool used in capital budgeting, the NPV method has several limitations. In particular, the NPV method uses estimates and assumptions about future cash flows and discount rates. Mollah et al. (2021) state that these values can be challenging to forecast precisely, meaning that the NPV calculation may be subject to uncertainty and error. The shortcoming could lead to incorrect conclusions about the viability of a project. In addition, the NPV approach may only factor in some crucial factors that could affect a project’s profitability, such as competitive dynamics or variations in market conditions. For example, Dollar Tree (n.d.) indicates that competitors exert pressure on the company’s capital decision making. The effect extends to impacting on the company’s sales revenue and profitability.
In conclusion, capital budgeting decisions are an integral part of management in public companies aiming to maximize shareholder welfare. Public companies encounter situations where they have to choose one among many competing project alternatives. Several approaches can be applied, but public companies prefer the NPV method. The majority of companies use the NPV approach for evaluating investment projects. NPV is preferred as it is a discounted and sophisticated capital budgeting technique and is unbiased and objective. The method faces limitations in finding the correct estimates and assumptions about future cash flows and discount rates. However, it remains the most widely used capital budgeting technique among public companies because of its ability to accurately assess the profitability of a project and its widespread acceptance and recognition. Using the NPV method, companies can make informed decisions about which projects to invest in and allocate their capital most efficiently and effectively.
References
Dollar Tree (n.d.). 2021 annual report. Web.
Mollah, Md. A. S., Rouf, Md. A., & Rana, S. M. S. (2021). A study on capital budgeting practices of some selected companies in Bangladesh. PSU Research Review, ahead-of-print(ahead-of-print). Web.