Critique of the Capital Budgeting Models

Introduction

Capital budgeting techniques refer to the methods used by a firm to appraise its projects. These capital budgeting decisions are essential to an organization’s success because they involve huge cash outlay; when committed, a project becomes sunk cost. Secondly, a firm must decide on the most viable project to invest in, and it must decide on how to get funds to repay the committed funds.

Models of Capital Budgeting

Capital budgeting models are Net Present Value (NPV), Pay Back Period, profitability models (PI), Internal Rate of Return (IRR), and the Accounting Rate of Return (ARR) (Cooper, Morgan, Redman, & Smith, 2002, p.16)

Critique of the Models

Whenever a firm invests, there are several years the firm has to wait until it recovers the initial investment usually referred to as the payback period.

Cooper et al. (2002) state, “there is a lot of criticism advanced towards the PBP and ARR methods of project appraisal because they ignore the time value of money and the size of the investment” (p. 16). The method does not consider the cash flow during the whole process. Due to this, the method fails to measure the profit attributable to a project; rather it calculates the period required to repay the initial cash outlay. PBP does not give precise criteria for decision-making, especially in cases when the company has a problem in deciding the minimum acceptable payback period. The method is inconsistent with the firm’s objective of wealth maximization. Moreover, the PBP does not consider the returns from the investment after the recovery of the initial cash outlay.

On the other hand, the difference between the present cash inflows and outflow is the Net Present Value. A firm accepts a project if it generates a positive NPV and when the NPV is negative, the firm rejects the project, and it becomes indifferent when the NPV is zero. The criticism of NPV is that it does not consider the size of the project. “NPV assumes that the intermediate cash flows of the project are reinvested at the required return” (Cooper et al., 2012, p.16).

PI has faced criticism due to its inconsistency in maximizing shareholders’ wealth, and it assumes that the discount rate is consistent and known, which may not be the case.

Managers who use the models criticize the initial cash inflow less than the cash outflow (net cash flow) method because the decisions reached from using the models do not coincide with the net cash flow method. This makes the decision-makers hesitant in arriving at decisions based on the unsure cash flows. This shows that they do not trust the models fully. “The choice of discount rates to use in this model is also of concern. An inappropriate discount rate gives a low net present value or a high hurdle rate leading to a negative signal about the project” (Cooper et al., 2012, p.16).

Another issue raised by the models is comparison. According to Cooper et al (2012), “managers assume that without the project the status quo will remain while in reality”; what is more, conditions will be different depending on changes within the environment. One has to carefully and in detail take a look at the conditions that “exist without the projects and with the project in order to ensure correct comparison with appropriate benchmark” (p. 16).

Conclusion

The other criticism of the model is that the decision has to rely on quantifiable cash flows only. With a high-tech environment, projects involve total redesign of the manufacturing environment to improve on the qualitative aspect of the firm. However, it is impossible to quantify the benefits of such systems. The idea of improving customer satisfaction through innovation requires refitting the organizations’ systems. It is not easy to deduce the benefits derived from these systems.

Reference

Cooper, W. D., Morgan, R. G., Redman, A., & Smith, M. (2002). Capital budgeting models: theory vs. practice. Business Forum 26(1/2), 15-19.

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