Capital Budgeting Excellence in Financial Management. A research on Cargil Ghana Limited
1.0 INTRODUCTION AND BACKGROUD OF THE STUDY
Cargill is an international producer and marketer of food, agricultural, financial and industrial products and services. Founded in 1865, its privately held company employs 142,000 people in 65 countries. They help customers succeed through collaboration and innovation, and are committed to sharing our global knowledge and experience to help meet economic, environmental and social challenges. Just like any other company, capital budgeting is a required managerial tool for Cargill Ghana Limited. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, at Cargill, the financial manager decides whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.
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According to D.W. Carlton and J.M. Perloff (2005) in their book Modern Industrial Organization, capital budgeting is the backbone of financial economics. Related topics in financial economics include: the time value of money, the meaning of net-present value, accounting concepts consistent with present-value calculations, discount rates, and option valuation techniques. In the public sector, the term is often exclusively associated with infrastructure investments — plant and equipment. It is more properly associated with all policy choices that have significant, long-term consequences: especially decisions about missions, programs, products, processes, or procedures. There are standard solutions to several kinds of capital-budgeting problems: make or buy decisions, investment in working capital (especially inventories) decisions, maintenance-level decisions, project selection, the choice of mutually exclusive investments, and investments in plant with fluctuating rates of production. However, the same basic calculus of benefits and costs is supposed to guide all classes’ policy choices with long-term consequences.
Donyananda et all (2002) indicated that, a capital budget includes planned outlays for capital assets with long expected lives and which are designed to produce income or support operations. These usually exceed cost minimums as dictated by accounting and/or tax rules, and include, but are not limited to: Land
Furniture & Fixtures
Investments in Other Companies
Also according to accounting and tax rules, and varying by type of asset, the expenditures made on capital items such as those listed above normally are spread over a number of years for the purposes of computing net income. 1.1PROCESSES OF CAPITAL BUDGETING
A company undertakes capital budgeting in order to make the best decisions about utilizing its limited capital. For example, if you are considering opening a distribution center or investing in the development of a new product, capital budgeting will be essential. It will help you decide if the
proposed project or investment is actually worth it in the long run. (Scott Foresman, 1990). Scott (1990) stated the following processes for capital budgeting: Identify Potential Opportunities
The first step in the capital budgeting process is to identify the opportunities that you have. Many times, there is more than one available path that your company could take. You have to identify which projects you want to investigate further and which ones do not make any sense for your company. If you overlook a viable option, it could end up costing you quite a bit of money in the long term. Evaluate Opportunities
Once you have identified the reasonable opportunities, you need to determine which ones are the best. Look at them in relation to your overall business strategy and mission. See which opportunities are actually realistic at the present time and which ones should be put off for later. Cash Flow
Next, you need to determine how much cash flow it would take to implement a given project. You also need to estimate how much cash would be brought in by such a project. This process is truly one of estimating–it takes a bit of guesswork. You need to try to be as realistic as you can in this process. Do not use the best-case scenario for your numbers. Most of the time, you need to use a fraction of that number to be realistic. If the project takes off and the best-case scenario is reached, that is great. However, the odds of that happening are not the best on new projects.
After you look at all of the possible projects, it is time to choose the right project mix for your company. Evaluate all of the different projects separately on their own merits. You need to come up with the right combination of projects that will work for your company immediately. Choose only the projects that mesh with your company goals. Implementation
Once the decisions have been made, it is time to implement the projects. Implementation is not really a budgeting issue, but you will have to oversee everything to be sure it is done correctly. After the project gets started,
you will need to review everything to make sure the finances still make sense.
1.2 Statement of the problem
In the form of either debt or equity, capital is a very limited resource. According to Mishkin (2005) there is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, corporations, and governments. In addition, the Federal Reserve System requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers. But even if a bank were to extend unlimited loans to a company, the management of that company would need to consider the impact that increasing loans would have on the overall cost of financing. Mishkin and Bernake (2002) suggest that, in reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. Mishkin (2005) later argue that, a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders. In other words, as the number of shares of a company increases, the company ownership of the individual stockholder may proportionally decrease.
The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on. Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital (Mishkin and Bernake, 2002). Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This,
in essence, is the basis of capital budgeting. 1.2.1 BASIS OF CAPITAL BUDGETING
Shanmukha and Suryanarayan (2000) indicated that, the problems in capital budgeting decisions may be as follows: a) Future uncertainty: Capital budgeting decisions involve long term commitments. However there is lot of uncertainty in the long term. The uncertainty may be with reference to cost of the project, future expected returns, future competition, legal provisions, political situation etc. b) Time Element: The implications of a Capital Budgeting decision are scattered over a long period. The cost and the benefits of a decision may occur at different points of time. The cost of a project is incurred immediately. However, the investment is recovered over a number of years. The future benefits have to be adjusted to make them comparable with the cost. Longer the time period involved, greater would be the uncertainty. c) Difficulty in Quantification of impact: The finance manager may face difficulties in measuring the cost and benefits of projects in quantitative terms. For example, the new products proposed to be launched by a firm may result in increase or decrease in sales of other product proposed to be launched by a firm may result in increase or decrease in sales of other products already being sold by the same firm. It is very difficult to ascertain the extent of impact as the sales of other products may also be influenced by factors other than the launch of the new products.
Base on the issues raised in the research problem, the following are hypothesized. H0: There is a relationship between capital budget decisions and the option to choose investments with satisfactory cash flows and rates of return. H0: A capital budget includes planned outlays for capital assets with long expected lives and which are designed to produce income or support operations. H0: Cargill Ghana Limited follows the procedures in designing its capital budget plan for a particular period.
1.3Objective of the Study
Generally, this work seeks to examine the impact of capital budget on the decisions on investment, which take time to mature. This has to be based on
the returns which that investment will make. Unless the project is for social reasons only, if the investment is unprofitable in the long run, it is unwise to invest in it now. The study will specifically examine the following issues: An understanding of the importance of capital budgeting in marketing decision making at Cargill Ghana Limited An explanation of the different types of investment project An introduction to the economic evaluation of investment proposals The importance of the concept and calculation of net present value and internal rate of return in decision making at Cargill Ghana Limited. The advantages and disadvantages of the payback method as a technique for initial screening of two or more competing projects. Thus, for an international producer and marketer of food, agricultural, financial and industrial products and services like Cargill Ghana Limited, it would be interesting to know the process by which Cargill assess how to fund operations and new ventures through movement and management of assets. Capital budgeting is an essential part of any company’s decision-making process, whether the objective is to increase shareholder value, build a new manufacturing plant, or develop a new product. The reasons for re-evaluating or expanding how capital budgeting is handled vary, but the intention is always the same. With capital budgeting, the company gives itself the opportunity to reach for its expansion, solidification or re-organization goals with the confidence that future financial outcomes appear favorable. This literature will further add both evidence and literature about the effects capital budgets on management decisions of Cargill Ghana Limited.
1.4Significance of the Study
This research is of significance to the domain of industries and manufacturing companies as it extends the knowledge base that currently exists in that field. The concept of capital budgeting is relatively new to the majority of industries. The groups of companies who have chosen to embrace the concept and implemented the strategy have welcomed the budgeting and administrative benefits it has to offer. Therefore, research which explores the advantages of such strategy will help to raise awareness among those who are unacquainted with its potential applications and benefits within their financial setting. To illustrate the potential of a
company-based budgeting, the research investigated Cargill Ghana Limited currently using the capital budgeting. The findings which have resulted from this case study has the capacity to impact upon the method by which information technology skills are currently undertaken in companies. This study would be beneficial to the industries and manufacturing companies in the city as this study enhance the knowledge of the financial services providers and users about the possible issues on capital budgeting techniques. Furthermore, this study would be beneficial to the financial services providers and the users as this study would provide the necessary information on the different threats and attacks in industries. This would expectedly heighten the awareness of the providers and the users to equip a counterattack to possible threats. To the future researchers, this study can provide baseline information on the recent status of capital budgeting. Having justified its significance to the members of the capital budgeting group this research is poised to expand the general knowledge-base for further research into the area of capital-based budgeting strategy.
1.5 The Research Questions
This research seeks to demonstrate the practical applications of a capital-based budgeting strategy and provide the technical assistance needed for individuals to establish their own capital base management. The overall design was governed by a qualitative focus. To successfully address the research focus, a three step approach was used. In phase one the study sought to formulate a help guide which could be used by financial managers to assist in the budgeting process of establishing their own capital asset management decisions. Phase two studies Cargill Ghana Limited currently using Capital Budgeting strategy and phase three expanded on this information by examining current literature to suggest further applications for capital-based industries. The research questions this paper attempts to answer are as follows: 1. How do public organizations such as the Ministry of Finance budget for capital asset purchases? 2. How do private organizations budget for capital asset purchases? 3. Is it possible or appropriate to apply private organization capital budget principals to public organizations? 4. What private sector methods of capital budgeting can be used in Cargill Ghana Limited? 5. How do public organizations plan
and manage risk regarding capital projects? 6. What private sector methods and practices have been adopted by other public organizations? 7. What private sector methods or practices have been adopted by Cargill Ghana Limited?
1.5.1 Phase One
Phase One implemented a research and development methodology. Borg and Gall (1983) propose a process to design, execute and evaluate the effectiveness of a package. The product produced during phase one of the study was an industry based capital budget which provided financial managers with a guide to the installation, maintenance and integration of an e-books software package for private industry setting. After following the steps as outlined by Borg and Gall (1983) the final package was a product based upon research which is ready for use in the industries. Changes and alterations made during each revision stage were a direct result of feedback obtained via responses to a questionnaire. Financial staffs were selected to participate in the trialing of the product at each stage. The chosen staffs had wide ranging degrees of understanding in the area of budgeting and the function of the e-books itself. The purpose of this was to ensure the design of the package catered for the needs of both technologically advanced and technologically disadvantaged industries.
The questionnaire asked the respondents to answer specific questions about the package in terms of the content and general design by rating each category on a scale. Once this data was reviewed, alterations were made to the content and design of the existing package in preparation for the next testing period and final implementation into the educational environment.
1.5.2 Phase Two
The second phase of the study documented an “in situ” exemplar of best practice using capital budgeting technology in a way that empowers financial managers to encourage electronic information literacy skills and overcome some of the problems associated with its usage. The case study examined how Intranets are currently being used by some private and government-based industries to encourage the development of electronic information literacy
skills. Cargill Ghana Limited was selected to form the case study focus. When you’re trying to hit a profit number, every penny counts. One of the benefits of working with Cargill is that you can leverage the knowledge, technological advantages and sourcing and financial strengths we’ve developed through the decades to reduce your costs, operate more efficiently and find capital for growth. 1.5.3 Phase Three
Phase three sought to expand on the information gathered during the phase two case studies. Current literature concerning the use of Capital Budgeting technologies and strategies was reviewed and an explanation of how these concepts are applicable to users of an industry-based software was given. Furthermore, phase three uses a series of key information technology outcomes to address how the strategies can serve to prepare managers for the technological challenges of the future.
1.6Scope and Limitations of the Study
The study covers a sample of staffs from Cargill Ghana Limited as well as its capital budget for the past 5 years. As compared to other companies in Ghana, the study uses relatively smaller sample size for this analysis. This may affect the implications of results in comparison to that of other companies. 1.7Organization of the Study
The study is in five main chapters. Chapter one covers the introduction and objectives of the study, among others. The Chapter two examines Capital Budget in at Cargill Ghana Limited as well as the literature review and conceptual framework for the study. Chapter three concentrates on the data description and methodology. Chapter Four describes presentation, analysis and discussing of empirical results. The final Chapter, five provides conclusions and recommendations. 1.7.1Chapter One
Chapter one discusses the introduction as well as the background of the study. It will explain the research problem while justifying the need for the research. By providing supporting evidence from studies, this research aims to indicate, if any, deficiencies or gaps in this study. 1.7.2Chapter Two
This chapter provides a review on relevant literature. It considers the evaluation, assessment and critical examination of existing material or information with the view to provide correct perspectives for the current study. This suggests that, there will be an interrogation on the issues that were raised in the existing studies where necessary and demands the evaluation of someone else’s research work done, scholarship and ideas. This will provide a reasoned analysis of the research in the field that identifies the strengths and limitations of the research and scholarship of others.
This chapter is interested in knowing how solutions will be provided to the research problem. It will explain all the necessary procedures of how the information regarding the research is gathered, analyzed and findings represented. This refers to the appropriate methodology which briefly indicates the population and sampling issues, sample size, data sources, issues of instrumentation, mode of data gathering and data gathering instruments, ethical considerations and how to analyze and present the findings. 1.7.4Chapter Four
Chapter four will provide a view on data analysis and presentation of empirical results. This involves the descriptive analysis of the data to gain further insight into the data as well as the interpretation of meanings behind the data analysis. Logical and reasonable conclusions will be drawn based on the interpretation of the results. Here, data collected is positioned within the existing theories reviewed in the attempt to explore consistencies of findings with the evidence and theories. 1.7.5Chapter Five
This ultimate stage of the research process provides a plat form for offering policy recommendation based on the findings of the study. Based on the analysis of data collected, this chapter provides the overall conclusions and shows meaning of the findings and its implication on policy making. It will reveal how the current study connects with existing studies and even where they seem to differ. It will further on ensure that, the
recommendations are linked to the objectives of the study.
D.W. Carlton and J.M. Perloff; “Mordern Idustrial Organization” (2005), – pp 44 Alan C. Shapiro, “Capital Budgeting and Investment Analysis” (2005), pp 264 Pamela P. Petterson, Frank J. Fabozzi, CFA, “Capital Budgeting: Theory and Practice” (2004) pp 165 Don Donyanda , Richard Irons, Steve Harrison, John Herbohn and Patrick Rowland; “Capital Budgeting: Financial Appraisal of Investment Projects” (2002), pp 1-10 John Wiley & Sons Incorporated; “Financial Cost and Management Accounting” (2000), pp 662-669. www.pearsonhighered.com
APPENDIX – QUESTIONNAIRE
1. How do public organizations such as the Ministry of Finance budget for capital asset purchases? 2. How do private organizations budget for capital asset purchases? 3. Is it possible or appropriate to apply private organization capital budget principals to public organizations? 4. What private sector methods of capital budgeting can be used in Cargill Ghana Limited? 5. How do public organizations plan and manage risk regarding capital projects? 6. What private sector methods and practices have been adopted by other public organizations? 7. What private sector methods or practices have been adopted by Cargill Ghana Limited?