Published On:Monday 19 December 2011

Posted by Muhammad Atif Saeed

The capital budgeting decisions are a pair of the deciding factors for the success of the company. A number of factors combine to make capital budgeting decisions are perhaps the most important decisions taken by financial managers. First, due to the fact that the results of the decisions of capital continue for many years, the decision maker loses some of its flexibility.

The opportunity is also an important consideration in the capital budget, since the capital assets should be ready for action when needed.

Finally, the preparation of the capital budget is also important because the expansion of assets usually involves very substantial costs, and before that a company can spend a lot of money, must have sufficient funds available. Two examples of capital budgeting decisions:

Example 1. The Ford Motor Company decided in 1955 to launch a new model of car: the Edsel. It was powerful, elegant and well equipped. Ford invested in the new model and $ 250 million was released in September 1957. Although the amount of the investment was a record capital investment for a consumer product, the Edsel was still full of problems.

Not only had a tendency to stall, but its chrome, power and equipment attracted more attention than customers. Only after two years of its appearance the Edsel was recalled. He was one of the biggest mistakes in the evaluation of company projects. In addition to its initial investment, Ford lost more than 200 million during its production, about $ 2,000 per vehicle sold.

Example 2. Boeing decided to develop the 757 and 767 model aircraft. Boeing’s investment in these aircraft was 3,000 million dollars, more than double the total value of shares, according to the company accounts of the time. By 1995 the estimated earnings on investment exceeded 6,000 million dollars and the planes are still selling well. In 1996, Boeing had profits of 1,800 million dollars, but in 1997 suffered losses of 178 million dollars.

How to measure the success of a capital budgeting decision? Measured in terms of value. Good investment projects are more cost utilities. The implementation of good projects increases the value of the company, and therefore the wealth of shareholders.

Today’s investment provides future profits. Note that the CFO is interested only in the volume of profits, but also on when you expect to receive. The sooner you get the return on investment, better But note that these utilities are rarely known with certainty: a new project could be very successful, but could also be a tremendous failure. The finance manager needs to have a method for assigning a particular value to those future earnings uncertainty.

Funding sources

• Equity: Equity capital, including owners and shareholders contributions and funds generated by the company that accumulate in the reserve accounts.

• Resources outside:

• negotiated Liabilities: Debt. Example: Banks, debentures and bonds.

• Spontaneous Liabilities: Generated as a result of business activity: suppliers for example. Displayed automatically. Not considered in this analysis.

The required information needs within the organization vary by level within the organizational structure. The decisions of senior executives or general managers are less structured in the sense that there are recurring situations and thus no single prescription can be applied solution on the contrary, should be established evaluation criteria and points of view to every situation where many the data are inaccurate and should come from external sources and subjective risk and uncertainty environments.

Because it is impossible to determine and control all the variables or factors that influence a situation is being sought through models represent reality for its analysis is expected that decisions made are satisfactory and optimal decisions in the context rationality of who should make decisions (bounded rationality). The executives made decisions that will be deployed at all levels of the organization translated into more specific objectives and concrete actions at each level to the lowest levels. The information required in all these decisions represent the starting point to carry out actions that will ultimately affect the performance of the organization.

Information -> Decisions -> Actions -> Organizational Performance

The purpose of the performance of any organization is to create economic value, and therefore the global ultimate goal to be achieved by any management decision. The executives, according to the Theory of Agency, are engaged by a principal officers or owners to make decisions for themselves in order to improve profitability and value creation. However, these decisions are subject to dispute, given that executives also have other interests not related to financial aspects such as leisure, work flexibility, etc.. On the other hand, they also are more risk averse compared to the owners, as they put their position in game does not exist alternative activities as a means of diversifying risk in the event that a bad decision compromise their work. The same situation occurs in intermediate dependency relationships from a senior management executive with an executive of a specific unit. It follows that there is a problem of interest is called the agency problem is exacerbated when information is asymmetric and there is no way to verify the agent’s behavior. This happens when the executive holds information that his boss does not know, which may lead the executive to manipulate the information and make decisions not satisfactory to the principal, but satisfactory for the same agent as what is called moral hazard.

Bad decisions destroy value and is most evident in smaller organizations with fewer resources and capabilities to support a cumulative loss in economic value. Good businesses that create value are the result of good decisions and the efficient and effective use of resources and capabilities. This is how a small company that does not have accumulated resources or capabilities can achieve good business just because you have made good decisions.

Good Business = Good Decisions + Resources and Capabilities

This approach includes Robert Grant (1991) and Paul Schoemaker (1991) called “competitive strategy based on capabilities and resources” as a way to solve the generic strategy Michael Porter that if an industry were static little changed. Currently, strategies must be based on resources and capabilities difficult to imitate.

Resources are those tangible resources and quality that the company has accumulated over the years and usually have physical form and can be counted and give an economic value. In the competitive analysis are important because they allow direct comparisons of the assets of the competition.

The capabilities of an organization is the result of being able to develop and coordinate teams of resources working together. That is, is “the collective knowledge within the organization about how to coordinate and integrate technology skills with resources.” These capabilities differ from those assets that are not tangible and are immersed in the culture, systems and procedures of the company that can not be traded or imitated. One of the tools used to detect the capabilities of an organization is the Porter value chain.

Due to the rapid global environment, less standardized, with demanding customers and increased powers, good decisions can not guarantee future success on a permanent basis, but are a possible protection against poor performance.

Since value creation is the ultimate goal of any decision and the result of many factors, including interim targets for value creation are the competencies to achieve sustainable over time in each business and functional appearance to promote competence essential in the internal activities. This refers to strengthening the capacities of intangible assets of each company that it is impossible to imitate by others.

This will discard the traditional idea of ??assessing performance in purely financial terms is of greater interest to the owners as the profitability is a result retrospective conveys what has been done in the past. The new decision must be the result of a process should also consider a view toward the future and the environment, addressing not only the interests of the owners but also consider the interests of customers present, learning within the organization taking account of the intellectual capital and the efficiency of internal processes with customer focus. This will take into account the causal factors that affect the financial results.

The decisions that an executive holds in the top management of a company or individual units of an organization referred to as management decisions.

Management Decisions can be classified from the point of view of management in two types: Decisions Decisions Planning and Management Control. This is because a director or officer serves mostly decisions about planning (what it will do) and slightly less in the control within the administrative process (“is being planned?). The planning and control are closely linked at present due to the cyclical nature of the process, dynamic and adaptive environment of the organization.

The Management Control Decisions are somewhere between the decisions of Planning and Operations Control, and the latter should ensure the efficiency and effectiveness of individual tasks according to the implementation of the strategy. From here on control decisions will be referred to management decisions as a way to simplify control their behalf, as the operations control decisions are focused on transactions that require very little participation of directors because they are mostly systematic accurate and specific data which can be automated and use scientific tools (Example: Tuning the numerical control, inventory control, etc.)..

Due to the importance of strategy in this new environment and commitments emanating from this throughout the organization, planning decisions are confined mainly in the process called Strategic Planning is a systematic process that defines the objectives and formulate corresponding strategies to achieve this (What to do?) specifies the programs long-term action with the corresponding allocation of resources (how to implement them?). Planning decisions will be referred to when determining strategic decisions in the process of strategy formulation which defines the objectives for the organization and strategies to achieve them, they are the property of being largely proactive decisions, aimed at shaping the future or set a desired situation, in contrast Control Decisions are more reactive in nature and tend to anticipate a future problem pointed by a pointer or reference in the worst case take corrective action in response to a problem already happened. In control decisions there is a detector (measurement) that stimulates an evaluator (executive) to carry out an action. Control decisions are also referred to as Strategic Control to the extent that there is a strategy linked to it.

However, strategic decisions can also have a reactive character, especially when there are unanticipated changes in the environment. When this happens and a valid planning to address changes, it is called Opportunistic Planning. The normal case when it is programmed and performed with some regularity is called Formal Planning. Both are necessary to maintain the viability of the organization and the planning opportunities come when the problems were not anticipated by formal planning.

The decisions in both areas derive different results and actions. Strategic decisions are not systematically emerge as a response to the environment are more long-term future of the inaccurate data and are represented on a Strategic Plan that describes how it will implement the strategy, they are also expressed quantitatively through a budget.

The formulation of strategies for the executive requires a creative and innovative nature (“You have to compete less, must be won before the battle”) is not systematically derived from the conclusion of the analysis of threats and opportunities of the environment, can therefore from any source at any time.

The decisions of management control, on the other hand, are represented in an action plan that has less range and is more specific where you must solve a specific problem with a shorter response time. A corrective action plan in response to a problem first requires the specification for each objective appropriate indicators and targets where it is necessary to measure, analyze and diagnose the cause of the problem and then select from alternatives appropriate corrective action.

Credit to: Dr. Nestor Efraín Amaya Chapa