The importance of capital to a business cannot be overlooked. Any new ventures require capital as the primary resource and so do any improvements and expansions. The capital structure of a business stipulates the relevant sources of income together with the amounts. Capital structure is also called financial leverage. Financial leverage is the origin of funds required for a project by a business or organization (Baker & Martin, 2011). Capital budgeting, on the other hand, refers to the process undertaken to ascertain whether an organization’s long term financial investments are worth the funding. These could involve new machinery, new products, and research developments. This process entails assessing the investment sums, the potential expenses, and the expected cash flows. The whole process includes determining all the cash sales, then deducting the cash expenses, direct followed by indirect, then deducting the tax, and interest before adding back depreciation to obtain the appropriate cash inflows.
The process of capital budgeting involves the use of capital budgeting techniques used to determine whether a project is viable based on its returns. The project should be able to repay back the whole investment and earn profits to the investors. These techniques include the Payback Period, the Net Present Value, and the Internal Rate of Return (Posavac, 2015). The Payback Period is the amount of time taken to recover the amount of money used in the project. It only considers cash inflows to the point where the initial investment is settled. Its advantages are it is easy to understand and calculate. Its demerits are it ignores all cash flows beyond the payback period regardless of their significance and it ignores the effects of the time value for money. Using the payback period method, a project is viable if its payback period is less than the recommended payback time otherwise it is not viable.
The Net Present Value technique utilises the time value for money unlike its predecessor the payback period. It shows the present value of future cash flows discounted at the cost of capital less the initial capital outlay. The NPV criterion is more reliable than the payback since it’s more realistic as money vale changes from time to time as a result of inflation. The advantage of this technique is that it considers the time value of money and all cash inflows generated by the project. This gives a clearer picture of the contribution of the project to the wellbeing of the company. However, the NPV suffers from its inability to offer a return; it only offers a monetary amount. A project is considered viable if it has a positive NPV and unviable if it has a negative NPV. The Internal Rate of Return is the rate of return that results in a zero NPV. Its advantages are familiar to those of the NPV.A project is considered viable under this technique if its IRR is more than its required rate of return.
The use of any of the above techniques is dependent on the requirements of the management. If the management is interested in recuperating their investment and nothing else, the payback period is the appropriate technique. However, when the management is interested in the project offering positive cash inflows, the NPV and IRR techniques are better suited. The three can, nevertheless, be all used when the management is interested in both the payback period and the viability of a project over a long period.
References
Baker, H. K., & Martin, G. S. (2011). Capital structure and corporate financing decisions: theory, evidence, and practice (Vol. 15). Hoboken, NJ: John Wiley & Sons.
Posavac, E. (2015). Program evaluation: Methods and case studies. New York, NY: Routledge.