HI5017 Managerial accounting sample
HI5017 Managerial Accounting – Capital Budgeting
Capital budgeting (or at times referred to as only budgeting) is one of the most relevant factors in managerial accountancy, finance and management per se; primarily due to the fact that these budgeting techniques helps or enables business decision makers to strategize and attach success rates and priorities to the multiple options or alternatives that they have at their disposal. The definition or the principle concept behind capital budgeting is to evaluate and determine all long term investment in the field of machineries, intensive projects, plants, R&D, products, services etc. and suggest and derive insights on the lucrativeness of those initiatives; and its worthiness of being sanctioned and funded from the capital structure of the company.
In line with this, there are multiple techniques and methods which are used to perform such budgeting decisions such as net present value, internal rate or return and so on (would be discussed in depth in the subsequent sections of the project). The current project mainly focus on secondary and exploratory analysis to understand how budgeting techniques and strategies are applied in the different markets; and compare and contract each of them with the aim of identifying the best practices and the potential shortcomings in the existing processes.
The research project would also
include a categorical comparison of two research papers on budgeting; and then
derive insights on the key points to focus or takeaways which can then be
applied on specific firms.
Table of Contents
HI5017 Managerial Accounting – Capital Budgeting. 4
Introduction or Overview of budgeting. 4
Key methods of capital budgeting. 4
Research paper 1. 6
Explanation of budgeting in the paper. 6
Purpose of research. 7
Research questions. 7
Key findings. 8
Research paper 2. 8
Explanation of budgeting in the paper. 8
Purpose of research. 8
Research questions. 9
Key findings. 9
Similarities & differences in the findings. 10
Specific outcomes or lessons learned. 11
Capital budgeting (or budgeting) in business management terminology, is referred to the concept used to check and evaluate the overall viability of certain business initiatives or plans which may require employment of substantial material as well as human resource for implementation of the same. Now, in case, in the middle of implementation or post implementation of a particular project; the net productivity or output generated by the project is not as per the targets or planned behavior; it may lead to massive loss for the business. Hence, in order to prevent the same, capital budgeting is sought for in most business organization which uses numerical analysis to provide a monetary value (or rate) to the present viability or feasibility of the business.
In actuality, there are multiple methods of capital budgeting which business organizations can use basis their business priorities as well as the nature of the project or initiatives which they are trying to evaluate; however, in this section, a few important and generically used methods would be elaborated which are used by businesses. (Hartwig, F. (2012))
Discounted Payback period – The discounted payback period method is an improvement over the payback method; and is one of the most simplistic models followed by businesses to evaluate large scale projects. As is evident, majority of the large scale projects require certain amount of capital to be invested in order to start with the execution process; post which after a certain interval of time, the project seems to impact cash inflows. Therefore, the overall time required by the project to cover up the initial outflow of cash is termed as the payback periods. Now, an additional discounting factor has been added to ensure that the time value of money is taken into account as well. As per the trend, the lower the discounted payback period; the more viable is the project.
Net Present Value – Net Present Value (NPV), as the name suggests, refer to the current value of future cash flows (both inflow as well as outflow) post application of the discounting rate of interest. The mathematical formulae used to calculate the NPV of any project is mentioned below –
As is evident from the mathematical formulae shown above; here all discounted cash outflow is subtracted from the discounted value of cash inflow in order to bring all cash transactions to a single and comparable time frame. Once this is done; if the resultant number is negative; it indicates that the project has chances of more cash outflow than inflow; hence it is not feasible. Generally, a positive value of net present value is always desired for a project to be tagged as a feasible project.
Internal Rate of Return – IRR is often used in conjunction with net present value; and is defined as the discounting rate of interest which makes the NPV value to zero. The mathematical formulae for the calculation of IRR is mentioned below –
Post application of the given formulae; the NPV is equated to zero; and then the corresponding value of ‘r’ is tagged as the internal rate of return. In order to measure the viability of the project; a higher value of IRR is generally preferred. However, in order to benchmark the same, the IRR is generally compared with the weighted average cost of capital (WACC) which takes into account the capital structure, as well as the cost of debt and equity involved in the budgeting decisions. In case the internal rate of return exceeds the WACC; the project is seemed to be realistic and viable; else it is not the case.
Profitability Index – Similar to IRR, as mentioned above, profitability index (PI) is also related to net present value wherein this metric tries to build a relationship between costs and benefits. The mathematical formulae used to calculate the profitability index is mentioned below –
The profitability index of 1 indicates mere break-even and is the lowest tolerance limit of sanctioning a project. Generally, higher the value of profitability index; more feasible and lucrative the business is. With these backdrops; the next section would detail on two research papers and their point of view on capital budgeting. (Daunfeldt, S.O. and Hartwig, F. (2012))
The research paper which has been analyzed as a part of this project is titled ‘The Use of Capital Budgeting and Cost of Capital Estimation Methods in Swedish Listed Companies’ and is published in the ‘Journal of Applied Business Research. The paper talks in length about the different possible techniques and strategies which can be potentially used by businesses to calculate the budgeting feasibility checks; and which methods does Swedish companies generally wish to focus on – keeping in line their business context and their market dynamics in the forefront. (Hartwig, F. (2012))
CAPM and NPV are the most viable budgeting techniques which has been explained in the paper. The businesses generally use CAPM method to measure the cost of equity and then the same is complemented by the net present value in order to take a final call on the project. The CAPM model presents a correlation between the systematic risk of any investment or capital structure to the returns which could be potentially earned from the underlying assets.
The key objective or purpose of research is to design a sample of certain Swedish companies and understand the various mindset and strategies that the leadership and decision makers of these companies have in connection with capital budgeting. In addition to understanding the theoretical dynamics and mindset of the decision makers; the research also extends to understanding the application side of things as well i.e. the capital budgeting techniques which are prevalent in those companies, and at the same time, how are they applied in actual business. Apart from that, certain internal and external factors are also studied and analyzed in terms of their impact on the overall capital budgeting decision.
The research question for the particular research can be majorly bifurcated into two major sections – first is the primary research question and then the secondary research question. As is evident from the research study; the primary research question is very direct and obvious – ‘what are the capital budgeting techniques and strategies which are majorly followed by Swedish business leaders and managers to check the feasibility and viability of large scale projects and initiatives in their business organizations?’
Now, the primary research question has direct relevance to multiple secondary research question which are mentioned below for reference –
- How does managers implement or put the desired capital budgeting method into practice so as to ensure most relevant and practical results?
- What are the different internal and external factors managers and business leaders consider before providing a final decision on a YES/NO to project execution?
Basis the research questions, the method followed in the research is a primary research using survey questionnaire which are distributed to the CFOs and other senior leadership of the companies which are traded in Stockholm stock exchange. The responses are tracked and analyzed; before making a final recommendation on the same.
Based on the research findings, it has been found that the propensity of using capital budgeting techniques is a bit less in Swedish companies as compared to US businesses. However, the most prominent method for cost estimation is the CAPM model (which is used to calculate the cost of equity). And, for the capital budgeting perspective, the method followed is the NPV approach wherein the present value of future cash flows are calculated and analyzed.
The second research paper which has been referred as a part of the research project is titled ‘What Determines the Use of Capital Budgeting Methods? Evidence from Swedish listed companies’ which has been published on the ‘Journal of International Financial Management & Accounting’.
The research paper talks about the possible and potential factors which may govern businesses in Sweden to adopt capital budgeting techniques and strategies to streamline and bring in more rationale in business decision making. The paper suggests that the size of the company and the availability of accounting numbers play an important role in their inculcating and imbibing budgeting techniques in their business operations and planning.
The main purpose of the research explained in this research paper is to analyze the key factors which govern the business leaders and managers to choose a particular budgeting technique or strategy for their firm. Hence, it is seen that the second research article referred in this project is a continuation or a complement to the first – while the first research paper focuses on which capital budgeting method to choose; the second refer to the factors which govern the choice. In addition to that, the research also tests and checks the consistency of these factors as to whether the factors are consistent throughout the year; or is it periodic or temporal in nature and depends upon certain other key internal or external factors.
As usual there is a primary research question; and then multiple secondary research questions which are off-shoots of the primary research question. The primary research question for the current research paper is ‘What is the key determinant of the usage or selection of capital budgeting techniques and strategies for businesses based out of Sweden?’
Now, this primary research question has multiple secondary research questions – mentioned below for reference –
- Are there any causal factors which enables businesses to check the productivity of effectiveness of each of the capital budgeting methods; and then select one based on real-time data and information?
- Does these metrics and observations differ with time; or is it cross-sectional in nature? Apart from time, are there any other factors which determine the success rate, relevance or effectiveness of these capital budgeting techniques in relation to businesses in Sweden?
Basis the research objectives and questions; a survey questionnaire is prepared which is then distributed to the CFOs of different companies based out of Sweden and are listed in the Stockholm exchange. The reading and observations from the surveys would be considered to reach the factors which determine the choice of budgeting methods.
The first factor which played a considerable role is the size and scale of the company – large companies generally are more receptive towards capital budgeting methods and techniques as compared to smaller or medium scale companies. The second important factor of consideration is the availability and reliability of the accounting numbers; which brings forward an important factor of capital budgeting – termed as information asymmetry. Lack of symmetry or alignment in accounting reporting and tracking may lead to incorrect decisions; which may in turn cause heavy loss or opportunity loss for the business. In addition, it has been also noted that majority of the businesses move towards using recommended tactics (such as NPV, IRR etc.) for their budgeting process rather than non-recommended techniques.
Although the two research papers taken for this analysis are different in their own might and perspective; still they are complementary in nature. While one focused on ‘which’, the other focused on ‘how or what’ aspects of budgeting. The key similarities in findings and analysis of the two research papers referred are mentioned below for reference – (Watts, R.L. and Zimmerman, J.L. (2015))
- Both the papers advocate usage of recommended and tested techniques and methodologies for capital budgeting such as IRR, NPV, discounted cash flow and so on; rather than using non-recommended methods which are more in line to the customized needs of the business
- Both the papers focuses their analysis on Swedish firms; and aligns to the fact that these businesses are still in its nascent stage or evolving in the usage of sophisticated capital budgeting methods and policies. They are currently behind as compared to their US counterparts.
- There is certain level of alignment in objectives and goals of both the papers – both of them aims to cater to the practical or implementation side of things as well in addition to the theoretical aspects. For example – in case a business is following the ‘net present value’ mechanism; how is the firm interpreting the NPV concept and how actually are they using it in their organization to derive valuable insights; have been the focal points of both the research papers.
Despite most of the similarities; there are a couple of differences as well which are mentioned below for reference –
- Capital budgeting techniques selection and implementation has certain limitations specifically with the quality and alignment of information which is in the accounting framework and infrastructure of business. The second paper deliberates on the same stating that accounting availability and ingenuity is one of the key factors for businesses to imbibe capital budgeting techniques in their business domain. The first paper on the other hand advocates the usage of the CAPM model and NPV methodology for budgeting decision making. However, it does not focus on the quality or correctness of the forecasted cash flow which are being discounted to bring to the current period
- Another aspect of difference is the level of customization of differentiation in techniques used based on the demography of the firms. It is an obvious fact that not all businesses irrespective of the domain, services, industry, and size would focus or prefer to use the NPV methodology for capital budgeting decisions. The first paper lacks that insights i.e. how does the preference of the businesses differ with varying demographics and size of operations.
A key lesson learnt from the study of the two research papers is that the implementation or the interpretation of businesses regarding these recommended budgeting techniques may not exactly be the same as that in the textbook. There are certain customizations or modifications which are done by the business to suit their customized needs and environment. Also, there is a certain amount of abhorrence or avoidance amongst small and medium scale businesses to use this technologies and techniques to derive best possible results.
Other than that, the propensity to use these techniques also depends on the region of operations as well – as is evident from the fact that Swedish businesses are less interested or inclined in using best in class budgeting techniques as compared to their businesses in the US or other developed nations.
In addition to that, the correctness of the accounting set-up is also important factor here; as it would decide on the effectiveness and efficiency of the budgeting model used by the business. For example – in case the business is using the NPV technique; the efficacy of the technique depends on the reliability of predicting future cash flows in the best possible manner. If the prediction is not proper; the NPV would be misleading – thereby causing incorrect decision making.
Taking all factors into consideration; capital budgeting is a straight forward theoretical concept with precise and direct techniques and mathematical models; but it is a lot complicated and subjective from the implementation perspective; which requires sound business acumen to cater to the various internal and external factors which impact budgeting exercise.
Hartwig, F. (2012) “The Use of Capital Budgeting and Cost of Capital Estimation Methods in Swedish Listed Companies”. Accepted for publication in Journal of Applied Business Research (Vol. 28, number 6).
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Hartwig, F. (2012) “Swedish and Dutch listed companies’ compliance with IAS 36 paragraph 134”. Submitted to International Journal of Disclosure and Governance.
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