(role of capital budgeting in financial management, cost of capital in financial management)
The very definition of capital budgeting emphasizes its importance in every financial decision-making process. Capital budgeting is a systematic process used to critically analyze and evaluate the merits and demerits of an investment plan. Hence, any decision, whether to accept or reject any part of the proposed investment plan is important, as it will affect the growth of the business.
Capital budgeting can be and should be applied to all businesses, irrespective of whether it is a private limited, public limited, voluntary, profit organization, not-for-profit organization, franchise, or others. This is because it not only gives a quantitative measure of the business’ future successes but it also gives an estimate of the value earned from the intangible assets that a business will need to accomplish in order to sustain.
How does Capital Budgeting help?
It gives an exact idea of the rate of return that a particular investment plan will generate. In cases of not-for-profit organizations or other charitable activities, the rate of return will be measured against its intangible values such as public satisfaction, people’s goodwill, and others.
It is the best way to track, measure, and account for any activity that involves the flow of money.
It gives a better understanding of the different areas of risk that an investment plan will encounter in its due course.
It also calculates the feasibility of a project before its launch, thus it is best to carry out capital budgeting at the start to estimate the profitability of any investment project.
It is a good way to assess the effectiveness of all the decisions made during the investment plan and evaluate its effectiveness for future decisions.
It helps in deciding the financial profitability and in preparing strategic goals for the investment option both in short and in long-term.
It helps with decisions regarding new investment options, its evaluation, and preparation of the business model.
Capital budgeting can be considered as an excellent tool to predict future cash flows and this, in turn, helps in deciding whether to accept an investment project or not.
Based on the estimates and outcomes from a capital budget, decisions are made at different hierarchical and authoritative levels, thus enables the flow of information within an organization.
Organisations are in a better position to make decisions regarding project approvals when the capital budget is in order.
Thus, it is evident that capital budgeting helps with both financial decisions and investment decisions.
Even after five years of price growth in the housing sector, the housing market is still growing. Unbelievable though and some people feel that it could be a bubble ready to burst. However, the experts are of the opinion that the construction and selling activity in the US is going to surge ahead at a good rate.
The housing sector is growing
Reasons for growth in the housing sector are many and some of these are mentioned here-
- Low unemployment rates
- Demand is going up
- Supply of ready houses is less than demand or not adequate
- Reduction in both corporate and personal taxes
All these factors together are propelling the housing sector to a new level of expansion and prices will soar in the near future. From a studio apartment in New York to a huge four-bedroom house in the suburbs in California, all kinds of houses are seeing an encouraging pattern and their prices are going in only one direction, upwards. The year on year gains is increasing phenomenally.
What can you do?
When the sector is growing so well why should you be left behind? You can invest in the real estate business in a planned manner to get the maximum advantage from this boom.
- You can buy a rental property. You can buy and rent out some part or the entire property. Even if you take a mortgage, the rent and maintenance would cover that and some extra income will be there and later the property is yours to use the way you want.
- You can buy an old house. Repair, renovate and then sell at a higher price. This is not easy though and may need lots of hard work and patience.
- You can use a concept of crowdfunding. Sounds strange for a real estate. Here you can invest your money in a real estate company, or a particular project, through debt or equity. To lower the risks of your money invested in the project, ensure that you use only accredited projects and companies.
- You can invest in REITs, which are similar to a mutual fund, but in real estate.
- Last but not least, you can rent out some part of your property as a homestay and use it for making money.
The real estate market is looking very buoyant. Both new houses and existing homes are looking at an increase in prices and demand. With all aspects being favorable, this sector seems to be on the cusp of a boom. You must invest according to your capacity to take risks and the amount that you can easily spare or repay and find the best tax saving slabs as well. This is a great sector for long-term investment and you can easily invest in reality for great returns.
Can anyone carry out financial modeling? Yes, provided they know the variables, different types of traditional and advanced models, valid assumptions and the purpose. Another important question is why should you construct a financial model? The answer may be, as a part of your profession such as an accountant, finance manager, corporate financial advisor, investment banker, equity and market research, business valuation etc
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There are several courses inclusively and exclusively related to financial modeling. Some of them are offered by reputed and authentic educational centers and will help in molding you into a potential expert, however, real expertise comes from constant practice, learning, and experience. You can do your own homework by constructing models based on market data available in the public domain or real data collected from your own firm. It is advisable to always start from the most basic flat-line model and then progress upwards.
Two ways to start and simple steps to proceed
As a startup, the company needs a well-defined plan of the capital cost accountable, funds with them, expected expenditure and how long the available funds will help them to move forward. This is done by building a startup financial model, which determines the future operation of the firm. You need to know your cash and its flow for the future so that you get an idea of how intensively you have to call for investment and how to put your assumptions to lure investors.
As a startup, you can construct a model in two ways depending on the final purpose. Explaining with an example; your company aims to introduce a new range of cosmetic products in a new market and you need to attract investors for the same. Here, you follow a bottom-up method, notifying about the future plans and expansions regarding the product introduction with the current and future extrapolation of the company’s financial performance.
Alternatively, you have an almost specific fund figure to raise in a financial round and you intend to utilize this fund towards any company goal. With this fund, you can project the expected revenues, cash flows and profits in the futuristic model.
Five simple steps for the construction
- Gather and generate the resources for the startup model such as credible assumptions, income statement, cash flow statement, balance sheet and supporting schedules (capital assets, interest, debt etc) of the model.
- Carry out business valuation or discounted cash flow analysis and interpret the results.
- Perform sensitivity analysis of the model and also add the scenarios by changing the assumptions for risk assessment and planning.
- Present the model in the form of Excel spreadsheets including charts, graphs, and formulae.
- The final step is to confirm that your model behaves even under extreme stress and pass out of the audit.
There is a lot of emphasis on risk management in the financial market. To be with it is first important to understand what risk management actually is.
Risk management refers to identifying, analyzing and accepting or mitigating the uncertainty in the investment decisions that one makes. A fund manager or an investor would manage risk. This lets him quantify what the loss potential could be if he invests in a particular investment. He then takes an appropriate action based on what his risk tolerance level is and also based on what investment objectives he wants to reach.
There are a number of financial risks that are involved when one makes any investment decision. The financial instrument that one chooses to invest into will determine the amount of risk that is associated with it. Thus a bank savings account carries very less risk as compared to investing in the stock market.
There could be other risks too like volatility in the market, recession or high inflation.
It is important that these risks are either controlled or minimized and for that risk management is practiced. It is very crucial that proper risk management is followed else the investments could lead to washing away your capital in a single go. Bear in mind that every asset class would have a different risk associated with it and thus any asset class that you invest in has to be analyzed separately.
How does one manage the investment risk?
There are some ways in which the portfolio risk could be managed.
If you are investing in the stock market or any other asset class then it is important that the investment follows the trend. This will increase the chances of being profitable. This also helps in minimizing risk.
It is important as a longterm trader that you manage your portfolio periodically. This is especially important if you are having an asset class that is taking a big percentage of your entire portfolio.
To manage your risk all that you need to do is to manage the size of your exposure. This means that in case you are trading in stocks and have a predetermined risk, then back-calculate using the stock price and the stop loss amount to arrive at the number of stocks that you can take.
It is important that you spend ample time to write a good business plan for your new business. The business plan throws light on what service or product your company is into and how to do you earn the money. It also should state what the business aims to do. Thus a business plan is basically a marketing method for your company that will let the reader know that your company is worth investing into. It is only when investors get excited about your company will they want to invest in it.
The three basic rules to writing a business plan
There are three key rules that should be followed when writing a business plan.
Keep the plan short and crisp – The business plan should not be lengthy and boring, it should be precise. You want that someone read a business plan and if it is 100 pages long then no one is ever going to read it. A business plan is something that will keep changing with time. It is a tool that will let you run your business and you will have to make changes to it. If your business plan is long and lengthy then you will face a lot of hassle to work on it.
Understand your audience – Your business plan should be in a language that your target audience will understand. Like if suppose you are into a business that is related to scientific equipment however your target investors are not from a scientific background. Herein case you have a business plan with lots of scientific jargons then the investors would not understand your product well and would eventually lose interest in the same. Make your investors understand your product in the simplest way that you can. If the investor can relate to what you are selling then they would be interested in the same.
Do not get frightened –Most of the investors will not be experts and they are just like you who have a degree in business. If you have a business and are passionate about it then writing a business plan and selling it should not be that challenging. Also, you do not need a business plan that is very detailed. You can just start simple.
How should your business plan look like?
The business plan should normally look like this.
The cover page
Table of contents
The background of your company and the summary of the opportunity
Address the opportunity in the market. It should include research and competition. It also should include the customers and the end users as well as the sale and marketing strategy
Services and products offered
The people behind the business
What is the source of funding is and how do you plan to proceed with it
The income approach to carry out a business valuation of a company is based on the concept that the value of a business lies on the economic profit expected in the future and risk level to be associated with the investment. The fair market price of the business product or the company is determined in terms of the net present value given by the benefit stream with respect to the discount or capitalization rate. The benefit stream covers the most valued and almost all important sources of income interested by the concerned of the company. The discount rate is obtained from the data and statistics given by the respective public companies and gives the value of the expected returns from the company in the present market.
How is discounted cash flow or DCF calculated?
The discount rate can be defined as an economic element essential to make investors or buyers to get attracted to your business and accept the company strategies and the risk associated with it. It is used to calculate the DCF by estimating the expenditure of the business including capital and infrastructure. From the investor’s side of benefit, a discount rate is the expected rate of returns from the business for the investment. This value then serves as the basis for determining the net present value in income approach. The most common methods of calculating discount rates follow the principle that the income from the business enterprise under consideration keeps on growing at a constant rate over the specified time period. There are two important elements of discount rate:
- Rate by excluding the risk factor and taking only the expected returns from the secure investment, known as the risk-free rate
- Rate by including the compensation of risk given to the investor above the risk-free rate, as a premium depending on the investment
For the preliminary collection of data required for calculating DCF, include the revenues and expenditures over a specified number of years and estimate the profit by removing the expenditures to get the net cash flow. Apply the estimated discount rate to each year’s profit, which gives the net present value of the expected profit in the future. You can also consider taking the net present value at the end of the subject period, known as the terminal value for calculation. For DCF, you need to know three values:
- The inflation rate
- The number of years to be considered
- The accurate discount rate
What you get in the end after incorporating all three values is the discounted cash flow value.
Stock market fluctuations have a great impact on start-up companies, as the very essence of a start-up company’s valuation depends on its market value.
Positive Aspects Regarding Market Fluctuations:
It adds immense value to the business.
It provides new and better means of earning more capital to run, develop, and even expand the business.
It creates a highly economical market value for the company’s shares.
It is the most convenient and transparent way to publicise the company to the public. This will in turn in enhance trust and loyalty from both customers and suppliers.
It displays the company’s investment portfolio in a better picture to the company’s stakeholders, especially the shareholders, investors, and venture capitalists, thus providing a clear platform to visualize their individual investments.
It provides its employees with an opportunity to be a part of the company’s shares. This is highly beneficial, as employees view this particular proposition as an extra employee incentive, which will motivate them to perform better and increase the company’s overall valuation.
Negative Aspects Regarding Market Fluctuations:
The most important aspect that will be affected by market instability is the cost. Several costs have to be addressed during this period and the cost incurred by the company due to all this could be substantially very high.
Another major aspect that gets affected due to market volatility is the company’s responsibilities to its shareholders and investors. Market fluctuations is a testing period where the company’s own objectives will be gauged against the interests of its shareholders who have invested their money in the running of the organization. As these begin to differ, the company will face difficult decision-making.
Not everything can be controlled. Therefore, the company might encounter situations where it becomes vulnerable to the market fluctuations, which could go beyond the control of the management or the company’s CEO. Some of the factors that are uncontrollable are economic conditions, market sentiments, and local & national developments surrounding the business.
Additionally, this is the time when there is little transparency in the business operations and goals. As a rule, companies will need to adhere to regulatory requirements and adopt standard operating procedures. However, these may differ from market fluctuations in order to protect shareholder interests and maintain investor relations in order to keep them interested in the company’s shares.
In addition, it will result in workflow disturbance among the staff and the management team, as the outside stock market fluctuations fuel distractions that lower their productivity.