Capital Budgeting: A Case Study Analysis of The Role Of Formal Evaluation Techniques In The Decision Making Process For Answering The Provided Questions.
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Capital budgeting is important for the organisations to improve measurability of finance and accountability that helps them to invest proper resources for the project after identifying the risks. The long-term investment and expenditure can be identified by the companies to ensure business suitability and gain competitive advantage in the market (Fehrenbacher et al., 2020). The present report analyses the capital budgeting process of two companies that are mentioned in the case studies and evaluates the factors that are considered for their decision making.
It is identified in the case study that the Firm A focuses on relocating their sisal matting plant from Polokwane in order to cost minimisation and export promotion. As there is limitation for product diversification in the sisal carpeting market, relocating can provide competitive advantage to the company. Polokwane production plant has low levels of productivity and losses relative cost advantages and there is also increasing importance of export sales that is almost 30% of total sales of this firm (Gilbert, 2015). Therefore, the decision regarding relocation of the production unit has utmost importance for Firm A.
On the other hand, as per another case study, South African paper manufacturing company, Firm B initiates the capital investment decision making process to increase their production capacity for long term profitability, high operating efficiencies and continuing the market dominance (Pathirawasam, 2016). The division wants to produce the products at lowest possible costs and maintain excess capacity to block the potential competitors from entering the market. As the growth of the market demand is increasing, product differentiation can provide long term competitive advantage and enhance sales.
The cost structure of Firm A is not good due to negative productivity of the firm that increases their operating and production costs. The plant also focuses on domestic production and only has estimated the direct costs from the domestic market in their profit/loss statement that depicts lack of export promotion. However, the annual growth rate of the export market is 15% with 7% demand compared to the domestic market that has a 5% growth rate.
The cost structure is comparatively good for Firm B especially for their “Tissue Paper Division” that has a market share of 37% in South Africa. A beneficial cost structure and capital investment helps the company to maintain dominating position as well as capital expenditure proposals also motivates this division to take new decisions for product diversification. This division completed their capital expenditure planning based on three scenarios such as 5% 10% and 15% of annual growth in market demand or sales.
Capital budgeting refers to a business process that is used to determine which proposed fixed asset purchases should be accepted and which one should be declined (Kengatharan, 2016). A quantitative view is created to determine the investment on every proposed fixed asset and judgement is made on rational basis. Firm A and Firm B both use capital budgeting tools to minimise their company profit by calculating the future accounting profit of their project. However, Firm A focuses on capital investment for relocating their plant to capture export market and minimize production costs but Firm B focuses on product diversification and maintenance of market dominance with the help of capital budgeting process.
Some processes are followed in the capital budgeting process such as,
- Identification of investment opportunities: In this first stage, the available opportunities for investment is analysed and a sales target is set for the future. For this purpose, SWOT analysis is conducted to determine the strengths and weaknesses of a company and a corporate strategy is created based on this analysis. Firm A has identified that the company has low production rate and high cost in Polokwane plant and makes a decision to relocate the plant for export promotion and reduce costs. Firm B has completed SWOT analysis to find out the opportunity in enhancing capacity to increase sales and dominate the market.
- Generation of proposal: A proposal is created by various authorised persons in the organisation to determine the classification of investment such as replacement, expansion, development, welfare investment and others (Fehrenbacher et al., 2020). Firm A has made a proposal for relocating their plant from Polokwane and has three options such as island location Johannesburg, coastal location Durban and foreign location Mauritius. Firm B creates capital investment proposals for capacity increment in tissue plants. The options taken by Firm B are,
- Rebuilding paper machine (PM) 3
- Upgrading the paper machine 4
- Renegotiate the supply contract
- Building of new machine
- Upgrading stock preparation using new technology
- Option E with external equipment
- Combining PM3 and PM4’s stock preparation
- Only upgrading PM4 stock preparation
- Decision making process in capital budgeting: In this part, decisions are made after evaluating the importance, effectiveness and long-term sustainability of the new development. Firm A has made the decision that Mauritius is most effective for export promotion due to its location, absence of company taxation, low internal transport costs. It can reduce company production costs. Firm B has taken the option E to upgrade stock preparation of PM4 through technology because it can provide additional capacity to meet expected needs of tissue plant division and improve its operating efficiency (Gilbert, 2015).
- Preparation of capital budget: In this step, higher and smaller investment values are calculated for proposals that are created by Firm A and Firm B and necessary approvals in capital budget are taken by the authorised people.
- Implementation: The time required for the project is analysed as well as required costs and resources are evaluated. In this part, formulation of the project is completed with necessary detail. Responsibility accounting principles are utilized for cost control and specific responsibilities are divided among the project personnel to successfully complete the project on time with proposed costs. “Critical Path Method (CPM)” and “Program evaluation and review technique (PERT)” are used followed by Firm A and Firm B to implement and monitor projects.
- Performance review
The actual result is compared with the projected result by Firm A and Firm B to determine whether the proposal is beneficial for the companies to reduce costs and maintain sustainability.
The foreign location, Mauritius is selected to relocate their production plant from Polokwane to reduce the production costs and export sales. The other factors that are considered by Firm A to relocate their plan are access to a flexible, cheap and reliable transport network for exporting the finished goods. They also consider availability of production premises, access of staff and support infrastructure to maintain the quality standard of sisal matting (Katjiruru, 2016). This location is selected because it has lower wages, absence of company taxation, low internal transport cost that is effective for managing costs and export products directly to the European market. Other options such as Johannesburg, Port Elizabeth and Durban are not selected because it limits flexibility as well as increases cost of raw material and transport.
Although relocating to Mauritius can increase profit and reduce costs, it has potential risks because it has a new economic and cultural environment. Real Options theory is used to remove key uncertainties that are different from traditional models. However, to maintain accuracy in formal evaluation, Firm has decided to keep a production facility in Polokwane for one year and set up a pilot plant in Mauritius to remove uncertainties and improve profit.
Option E has been selected owing to the following reasons:
Though option F has the highest IRR, it suffered from issues of technical faults which might have affected the productivity level of the associated machinery but in case of option E it is supposed to allow PM4 to run at its original capacity. This clearly states that the IRR measures are not the most important criteria for selecting the options as there are certain factors which need to be considered for evaluation. It also possesses the ability to rectify the support system and enhance the output grading and improve the efficiency. The use of R45 instead of R15 has also been prohibited since new technology would require replacement much later. It would also supply additional abundant capacity according to the required needs of the division. It would also help in prolonging the life of the PM4 machine and thereby improve its operating efficiency for a sustained period (Gilbert, 2015). Option E also provided the ability to minimise the additional investments which have been burdening the production capacity of the present assets. Furthermore, the management found out that the IRR measures were not quantifiable as the data would have been obtained only after the pre-engineering study.
In conclusion, capital budgeting helps an organisation to determine the long term investments for purchasing or replacing the machineries, plants, products or research development through capitalisation structure of the firm. Firm A decides to relocate their production unit from Polokwane to Mauritius to improve their export promotion and reduce costs because of low wages, no taxation and low transport costs of Mauritius. Firm B takes the decision to upgrade stock preparation of PM4 with technology to develop its additional capacity and dominate the South African market.
- The internal rate of return approach could have been used that may help in estimating the profitability of the potential investments.
- The net present value approach can be taken under consideration by the current firm as it helps in differentiating among the present value of the cash inflows and outflows for a reasonable period of time.
Fehrenbacher, D. D., Kaplan, S. E., and Moulang, C. 2020. The role of accountability in reducing the impact of affective reactions on capital budgeting decisions. Management Accounting Research, 47, 100650.
Gilbert, E. 2015. Capital budgeting: A case study analysis of the role of formal evaluation techniques in the decision making process. South African journal of accounting Research, 19(1), 19-36.
Katjiruru, T. G. 2016. A review of capital budgeting decisions in Namibia’s state-owned entreprises (Doctoral dissertation, University of Namibia).
Kengatharan, L. 2016. Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), 15-38.
Pathirawasam, C. 2016. Capital budgeting practices: Evidence from Sri Lanka listed companies. International Journal of Management and Applied Science, 2(5), 23-26.
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