Research Paper on Capital Budgeting and ROI & NPV

Introduction

Capital budgeting decisions is a system of allocating resources in the business in such as a way to maximize the profits and divided to the shareholders. The managers of any firm are pre-occupied with the capital budgeting decisions since the process is not easy but a complex one which requires pragmatic and well-calculated risk-taking. Research indicates that there is a direct relationship between return on capital investment and capital budgeting techniques applied. Net present value, on the other hand, it is used as a tool for investment planning and capital budgeting. NPV is referred to as the difference between the present cash outflow and inflows. A positive net present value indicates that an investment is worth and profitable since the costs are lower than the earnings generated by the investment (Sirinanda & et al. 2015).

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The return on investment is a very significant concept to the investors since it determines the number of dividends they are likely to receive. When a company realizes profit growth, the managers are faced with an uphill task of deciding how much is going to the investors regarding divided and how many shares will go to the investment to ensure that the profits keep growing (Lane and Rosewall, 2015). There are quite some investments that the managers may need to take into account such as investments in research and development, merger, acquisition, increased divided among the others. The utmost goal is to maximize the return on investment to the shareholders thus the managers will be guided by NPV to determine which investments are likely to yield more profits to the investors (Bobtcheff, Gollier & Zeckhauser, 2008). There are firm growth strategies such as organic growth which entails the equation of new equipment or opening branches overseas which will determine where the growing profits need to be invested.

Only investments with a positive NPV are worth spending resources to invest since those with a negative NPV result into a loss. When a company has increased profits, it is a reflection of how it has fared well regarding return on investment. It is a clear indication that the company is putting into good use the positive cash flows realized in the business. A company may increase its profits by completing an acquisition of another company through the excess profits realized from the best return on investment as part of its growth strategies (Lane & Rosewall, 2015). When such project yields positive results through increased NPV, then the project is worth investment since it would result into increased value for investors as well as the dividends they share from the return of investment for the expanded firm (Frost et al., 2014).

The management must first highlight priorities for the business operations based on the deep consideration of two important concepts namely return on investment and the net present value. The two concepts help drive the growth and competitiveness of any organization in the industry. The management highlight the organization priorities such as the need to pay divided, debts, generic growth, research for new products and then narrow down to considering investments both long-term and short term that would result into high returns for the shareholders (Sirinanda and et al. 2015).

Real Life Application of ROI

When a person invests in a company he expects to generate an amount of profit that will be beneficial to him or her financially. In my community, there is a hospital owned and managed by the Catholic Church whose name is St Francis of Assisi Hospital. It is both an outpatient and inpatient facility that targets the low-income earners in the community. Many describe it as a hospital for the needy. The medical system used in the facility was an old computer system that did not capture all the patient's data and the management felt the medical records system was leading to a lot of wastage in finances. The good thing with the old medical record system was that it was cheap to purchase and cheap to maintain since it did not require an external expert when the need arises. The disadvantage was that even with the system, the hospital still needed to employ a medical records officer who would ensure hardcopy files for patients records were safely kept and easily retrieved when needed. It also made it difficult for the hospital to track and manage the income generated leading to unexplained loses (Bierman and Smidt, 2012).

The hospital board of management discussed the idea of adopting an advanced electronic health management system that would help in generating more revenue and maintain proper records of finances and patient's data records. However, the new health management system for the hospital was expensive to acquire and manage for the health facility. This is the point that they had to consider the return on investment for the new health management system that could easily store both financial and patient's data and was easy to retrieve when needed without the nurse having to visits the medical records office. To install this system, the board was made aware that they have to purchase new computers that had the capacity to operate with the new system (Bragg, 2012). At this point, the board had to consider the return on investment of the new health management system to be adopted by the hospital. Return on investment is one of the best metrics to use when determining where to invest the available funds that are always limited in nature. Return on investment would help the hospital management board get to understand the financial benefit of adopting the new and more advanced health management system. Making a capital investment decision-based in the available resources that are limited in nature requires an in-depth analysis of the consequences of such a decision and return on investment will help the management determine whether they made the right decision or not. From the analyses given by the finance officer to the management board, investing in the new health management system and new computers would greatly benefit the hospital both financially and patient management (Brown, 2012).

Capital Investment Decision

The budget outlay presented to the board by the finance manager for the new health management system and new computers was 30,000 dollars. The hospital management had to invest in the purchase of new computers on which the new health management system would be installed and other required IT infrastructure. The labor and training cost had to be considered too. It is after consideration of all these factors that the hospital management would engage in cost-benefit analysis (Bobtcheff et al., 2008).

This was a lot of money considering that it required the facility to inject the funds at one go not in installments. A headache for the board of management was the source of these funds. It was agreed that getting a loan from the local bank was the only option which they did. They hoped that the new investment would generate more returns. This was the critical point at which they were required to be sure whether to make the investment or not by using ROI as a tool of analysis (Bragg, 2012).

After a period of one year, the board of management evaluated the return on their investment in the new system compared to the old system. Using the return on investment ratio to see if their capital budgeting decision was right, it was clear that adopting the new system was the right decision to make. The return on investment ration helped the management measure the financial performance of the new health management system compared to the old system more accurately and it was clear the return on investment was profitable. The profitability of the company rose by 20% after adopting the new health management system. The rate of profit compared to the cost of investment was 10% (Brown,2012). This was an improvement in the financial performance of the hospital compared to the past years. Uses of return on investment ration in decision making helped the board of management of the hospital decide on whether to adopt the new hospital management system or continue using the old system. Analysis using the return on investment ration helps the finance to objectively justify the investment to the board of management (Menachemi and Collum, 2011).

Measuring the return on investment depends on the hard cash received by the company after the investment is made and the cash can be linked to that investment. The financial records of the hospital were used to calculate the return on investment for use by the management and other stakeholders like the church leaders and the suppliers. The accuracy of the return on investment as a measure of performance depends on the financial records of the facility (Phillips, 2012). The return on investment as a measure of performance vindicated the board of management and it was clear to them that they had made a good capital investment decision by adopting the new health management system for the facility (Nas, 2016).

Conclusion

Return on investment ration is popular among many Finance Officers because it is easy to understand and straight forward that everybody including laymen that have no knowledge in finance. Its focus on profitability is another aspect that makes it popular to the management since it uses hard cash generated that can easily be gathered from the financial records of the company. Making a capital investment decision requires careful analysis by the management especially when it involves mutually exclusive projects that would lead to a heavy loss if the decision wrong. The data used in doing the cost-benefit analysis is available and can easily be accessed whenever needed by the management. ROI speaks for itself thus making it a popular concept for most financial practitioners and the management when it comes to making a capital decision that involves a huge cash outlay. Clearly, it was beneficial that the management in my local community hospital used ROI in determining whether to adopt the new more advanced health management system or keep the old health management system that required physical storage of files and only captured clinical notes. ROI is a concept that greatly influences how the strategic allocation of resources is done.

References

Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.

Bobtcheff, C., Gollier, C., & Zeckhauser, R. (2008). Resource allocation when projects have ranges of increasing returns. Journal of Risk and Uncertainty, 37(1), 1-33.

Bragg, S. M. (2012). Business ratios and formulas: a comprehensive guide (Vol. 577). John Wiley & Sons.

Brown, R. (2012). Analysis of investments & management of portfolios.

Frost, J. J., Sonfield, A., Zolna, M. R., & Finer, L. B. (2014). Return on investment: a fuller assessment of the benefits and cost savings of the US publicly funded family planning program. The Milbank Quarterly, 92(4), 696-749.

Lane, K., & Rosewall, T. (2015). Firms' investment decisions and interest rates. Reserve Bank of Australia Bulletin. June quarter, 1-7.

Menachemi, N., & Collum, T. H. (2011). Benefits and drawbacks of electronic health record systems. Risk management and healthcare policy, 4, 47.

Nas, T. F. (2016). Cost-benefit analysis: Theory and application. Lexington Books.

Phillips, J. J. (2012). Return on investment in training and performance improvement programs. Routledge.

Sirinanda, K. G., Brazil, M., Grossman, P. A., Rubinstein, J. H., & Thomas, D. A. (2015). Maximizing the net present value of a Steiner tree. Journal of Global Optimization, 62(2), 391-407.