This three page paper produces an argument that finance plays a significant roll in business decision making. It follows a standard thesis, body, and conclusion organization. There are four body paragraphs each detailing the required areas of capital budgeting. Includes quotes, internal citation, and six academic sources including one text book. This order is in APA format.
¶ … Investment Projects
The success of a business depends on risk-taking. Decisions must be made to move a company forward and ideally lead to greater success. However, risks are not taken in the dark, rather, every metric and angle of a decision is analyzed with great scrutiny by those with knowledge in economics. The findings are drafted into reports and decisions are made based on this information. This practice, known as prudent decision making is an essential fallback should a risk prove to be less advantageous than originally believed. So, in firms, finance plays a significant role in decision making through proper capital budgeting, sensitivity analysis, project ranking, and ability to quantify inflation.
Capital budgeting is the first factor that businesses utilize in their decision making process. According to Arthur Sullivan, capital budgeting is a "planning process used to determine whether an organization's long-term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures." (Sullivan, 375). In other words, capital budgeting is a means of ensuring that each proposed investment meets the company's overall goals and criteria for funding approval. There are multiple methods within capital budgeting that firms use when making a decision. Some examples of commonly adopted methods include calculations of net present value, equivalent annuity method, internal rate of return and profitability index. As a general rule, if an investment meets a certain numerical hurdle through these calculations, it will be presented to a board for approval. If it fails to meet the criteria, then other factors may be considered or the investment proposal may be dropped entirely depending on how risky it would actually be regarding the overall growth of the company. So, for many firms, capital budgeting reports provide an initial hurdle to determine whether a proposed project is prudent.
Sensitivity analysis is another method used by businesses to consider whether an investment is worth the risk. Sensitivity analysis is "the study of how the uncertainty in the output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty in the model input." (Pannell, 1997). Sensitivity analysis is almost always preformed as a computer model that outlines the possible robustness of a certain factor, simplify models, explore the cost of input factors, and recognize instability (Saltelli, 2005). For instance, a lumber company when considering investing in a new forest may run a sensitivity analysis to determine the overall loss should this new site be hit with a local disease. Sensitivity analysis only works for factors that are subject to change and provides a way to understand the worst case scenario should an investment fail at certain levels or completely. It is sensitivity analysis that can typically make or break decision making for a company, as investments that are too fragile would not be considered prudent by the board.
Determining the ranking of mutually exclusive projects is another step used by firms in the decision making process. Investments are determined on an annual basis by a business's board in agreement with and limited by the company's spending budget for the year. Once the capital budgeting and sensitivity analysis reports are complete on all projects, the projects are then reviewed on additional factors such as overall purpose within the company, and are ranked from best to worst (Bacon, 1977). Those projects that fail to meet certain numerical hurdles are simply eliminated from the list and not considered by an investment board. Some decisions may be close to certain numerical hurdles but also have other overarching reasons for acceptance. Some examples may include investments for improvements in compliance with legislation. These investments must be done regardless of their overall worth, and typically are more beneficial to a company if done sooner rather than later. Another factor that is often considered during this phase of decision making is the role of duration (Barney, 2004). Ideally an investment's initial cost is paid off within a minimal amount of time and can be reinvested into new projects. Should a project take too long, it will not be considered viable.
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