Aligning Strategy and Budget

Posted: August 26th, 2021

Aligning Strategy and Budget

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Aligning Strategy and Budget

Capital Investment Metrics

Capital budgeting involves evaluating investments or potential projects that are to be undertaken by a business. The investment evaluation encompasses the anticipated time to complete the project, the project scope, and the existing cash flows(Mohan & Narwal, 2017). The process is also referred to as investment appraisal. It determines whether the initial investment in a project would meet a sufficient target benchmark. Thus, the results are used for necessitating the decision to implement an investment strategy.

There are three main methods used in capitalinvestments. These are the internal rate of returns, payback periods, and net present value (Abor, 2017). The payback period (PB) metric calculates the time it takes to recover the initial investment in a project. It is given by dividing the aggregate cash inflows of a specific period with the initial financial outlay (Mohan & Narwal, 2017). Further, theinternal rate of return (IRR) or the expected rate of return refers to adiscounted rate when thenet present value is zero(Mohan & Narwal, 2017). In this case, whenit is established that the discount rate is more than the rate of return of the capital project, such a project is considered viable for investment and vice versa. Equally, the net present value metric is derived from discounted cash flows(Kim, Fallov & Groom, 2020). It factors in the time value of money in a capital project through discounting, making it the most effective method of capital budgeting.Hence, it involves utilizing the average weighted cost to discounts cash inflowsafter considering a tax on capital investment.

Role of Finance Managers in Capital Budgeting and Risk Tolerance

Finance managers should evaluate capital budgets to ensure it is aligned with the risk and mission of a company by considering factors such as the initial outlay, timing of the cash inflows, acceptable risk levels, and cost of debt. The project’s cash flow should be discounted using the weighted average to realize the exact return to the company after catering for the time value of money. Besides, the risk should be analyzed using sensitivity analysis to determine the acceptable level (Mohan & Narwal, 2017). Once this is done, it is therefore, upon the manager to decide if the company is risk-averse or willing to take risks in the project, which may be a stand-alone, corporate, or market risk.

Strategy and Capital Budget

Strategic planning is crucial in capital budgeting. The reason is that the conceptprovides direction, objectives, and guidelines to achieve the stipulated aims. As such, every employee in a company should be involved in capital budgeting to ensure they understand the strategies of capital budgeting (Kim et al., 2020). At the same time, they should be included in various stages, such as planning, monitoring, and implementation, to have a clear understanding. In this way, it will be possible to generate a sustainable competitive advantage in the company through the investment valuebesides strengthening its operational capabilities.

References

Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.

Kim, J. H., Fallov, J. A., & Groom, S. (2020). Integrating the Strategic Planning, Project, and Budgeting Cycles.

Mohan, V., & Narwal, K. P. (2017). Capital budgeting practices: State of the art. Asian Journal of Research in Banking and Finance, 7(4), 57-74.