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Literature Review of Capital Budgeting
The capital budgeting can be stated as investment decision making or planning capital expenditure and others. According to the (Brigham et al., 2013), capital budgeting is defined as the budgeting which is concerned with the formal process of investment of capital and acquisition of the company. The capital budgeting is necessary for taking investment decisions which impact in the long run and influence the risk factor associated with an investment. The capital budgeting involves the commitment of huge amount of funds, assessment of events in the future, ensuring of right selection of sources for financing over the particular period of time. According to the (Bierman et al., 2012)the variables of capital market includes agency cost and interest rates which impacts on corporate governance which in turn influences the result of capital budgeting. According to (Brigham et al., 2013) the capital budgeting has two sources, namely, equity and debt. The debt is defined as the external source which is taken at the specific rate of interest which is supplied from the capital market such as financial institutions, investment banks, and others. The interest is charged on the borrowings which influence the corporate governance of the company. The leading objective of capital budgeting is to maximize the wealth of shareholders which helps the company to grow and expend through making investments. According to (Bierman et al., 2012), the company can grow through investing in capital projects for example the purchase of land and machinery which helps to produce long-term revenue. According to Aggarwal, the capital budgeting is a very crucial decision of the company because it impacts on long-term financial implications of the company.
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According to (Graham et al., 2015) the capital budgeting decisions holds the differentiate features of exchange of funds for the assistances in the future, and it is endured by the company for the long term than the consequences of operating expenditures. The scholarship uses the term capital budgeting with decision making of investment and the appraisal of investments, so the capital budgeting is explained in different ways, in a nutshell, it is the decision regarding the allocation of resources by the company which helps to generate long-term profits of the corporation to maximize the wealth of shareholders in the long run. According to the (Bancel et al., 2014) the evaluation of information technology related investment should be made through traditional capital budgeting methods. The Information technology requires the use of more than one investment technique because it has multiple objectives with multidiscipline impact.
According to (Brigham et al., 2013) the investment, financing, dividend, and working capital decisions are included in corporate financial management. The capital budgeting is an important portion of management of corporate financials which needs continues consideration of other decisions of the company. The good financial management includes reviewing financial budgeting through forecasting of revenue and cost of the company, seeking financial opportunities for the expansion of the business, analyzing the financial position of the company through ratio analysis, acknowledges the various techniques for valuation of assets and project appraisals, and applying of appropriate technique. According to the Seitz, the net present value method is the most popular method which is used to evaluate the performance of the investment related projects. But the net present value method does not serve as the measure of performance for all the stakeholders.
According to (Bierman et al., 2012), there are several methods which are applied by the financial managers for the appraisal of investments. The capital budgeting methods are mainly divided into two categories, namely, discounting cash flow and non-discounting cash flows. In discounting cash flow techniques, the risk-adjusted rate is used to determine the present value and they involve the use of time value of money. The techniques involve internal rate or return, net present value, and profitability index. The non-discounting techniques do not consider the time value of money, discounting net future cash flow and business risk is also ignored. The methods include payback period and accounting rate of return. The accounting rate of return is used to take the management decisions of the company related to the investment appraisal, but the methods have limitations that it do not consider the time value of money, cash flow, and risk involves in it. According to (Goodman et al., 2013), the payback period is used to calculate the minimum time required to cover the initial investment of the project. According to (Graham et al., 2015),the methods has come limitations which include the equal consideration for all cash flows, not differentiating the size of an organization, and risk is not considered. It does not measure the profitability of the project. The internal rate of return method is used to describe the expected rate of growth the project will generate by accepting the project. The methods have various advantages such as consideration of risk, time value of money is taken into account, and cash flows are used in the methods. However, the disadvantages of the methods include the assumption of cash flow reinvestment at the rate of return which is equal to the internal rate of return and it provides more than one internal rate of return when the cash flow is unconventional.
According to the (Bierman et al., 2012), there is a conflict in the results which includes non-separation between the projects which are mutually exclusive and have a variant in sizes. However despite disadvantages in the method the Hendricks: Mukherjee: Anderson researched that it is the most popular method in the daily practices for the capital allocation decision in the companies. The profitability index is defined as the discounting cash flow method which is used to measure the profitability of the capital project. However, the method has some limitations which include the misleading of two mutually exclusive plans. According to (Graham et al., 2015) In the case of mutually exclusive projects the one project has higher net present value and other has higher profitability index then it is recommended that the project with higher net present value should be chosen. The net present value is the most popular method for assessing the performance of capital projects however the method has disadvantages which include the ignorance of financing cost. The advantages include consideration of time value of money, cash flow, project risk and maximization of the value of an organization. It is concluded that there is a gap between the theories and project. The investment appraisal decisions are obstructed by the accounting practices and capital markets (Ivo Welch et al., 2014).
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Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.
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Goodman, T. H., Neamtiu, M., Shroff, N., & White, H. D. (2013). Management forecast quality and capital investment decisions. The Accounting Review, 89(1), 331-365.
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Bancel, F., & Mittoo, U. R. (2014). The Gap between the Theory and Practice of Corporate Valuation: Survey of European Experts. Journal of Applied Corporate Finance, 26(4), 106-117.
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Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: Theory & practice. Cengage Learning.
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Graham, J. R., Harvey, C. R., & Puri, M. (2015). Capital allocation and delegation of decision-making authority within firms. Journal of Financial Economics, 115(3), 449-470.
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Ivo Welch, Y. (2014). Long term Capital Budgeting (1st ed.).
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