Capital Budgeting

Capital Budgeting

"Capital Budgeting is the process of determining whether or not projects are worthwhile. Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow and payback period" (Investopedia, Inc.). Capital Budgeting is an important part of corporations and small businesses because they aid in making key business decisions. Capital Budgeting can be looked upon as an appraisal of business investments. Lester Electronic Inc., has decided to undergo an acquisition of Shang-Wa electronics in order maximize its shareholders wealth. The success of LEI's investment decision is dependent upon their ability to define and mitigate possible financial risks involved with the decision.

The possible financial risks involved with acquiring Shang-Wa include asset quality problems, where one company may have a weak loan portfolio which can drain the financial health of the acquiring company. Accounting problems of the target company also present possible risks because the acquiring company may incur charges associated with restructuring and experience declines in intangible assets. Compliance issues may also present a financial risk to the acquiring company. If the target company is violation of tax laws or undergoing some for of litigation, the acquiring company could acquire legal fees and fines, although these issues may have emerged pre-acquisition. A decrease in the stock prices of the acquiring company is another possible risk for Lester Electronics'. Mark Thornton of the Quarterly Journal of Austrian Economics reported, "M&A can also affect demand if current shareholders find that the newly formed company is no longer appropriate for their portfolios. A decrease in stock price for acquisition firms is, therefore, not irrational nor completely unexpected." Mr. Thornton also adds that, "The largest companies are precisely the ones that are allowed the fewest opportunities to enhance shareholder value and are also the companies that come under the greatest antitrust scrutiny by government. If a large firm tries to grow too large, it can be accused of unfair trade practices, dumping, of trying to monopolize an industry. Large companies are also more likely to be prevented from expanding their business through vertical and horizontal integration because it might violate antitrust law. Likewise large companies are also more restricted from forming the most efficient mergers possible because such mergers might create too much market power or industry concentration"(Thornton, 1999).

Finally, inheriting the target company's debt and expenses is possible risk for Lester Electronics'. The target company's debt or expenses can decrease the value of the company and therefore, provide the acquiring company with a deal that has a negative Net Present Value. Nevertheless, acquiring companies can use a variety of methods to value their targets and therefore mitigate the risks associated with investment decisions.

Risk Mitigation

Risk management strategies are important in reducing and eliminating potential risks related to business decisions. Strategies such as; conducting due diligence, using the terms of the deal to get the seller to share in the risks, having a written transaction plan, and assembling an experienced acquisition team to consummate the deal can be applied in order to receive the best results. Other methods can also be considered in mitigating financial risks. Determining the strength of a company's financial portfolio can be determined prior to the acquisition. "Net working capital is defined as the difference between current assets and current liabilities"(Ross, 2005, c.7, p.14). It is a measure of the company's efficiency as well as its short-term financial health. If the company's current liabilities exceed its current assets this is a sign of the company's inability to pay back creditors in the short-term. "Net working capital may also define a company's operational efficiency, whereas, money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations."(MBS Financial, 2006). "A company's efficiency, financial strength and cash flow health shows in its management of working capital" (Investopedia Inc.). This ratio works best in comparing working capital from various time-periods.

In order to avoid possible financial risks involved with the target company's debts and expenses, companies must conduct due diligence. Due diligence is an investigation of companies in agreement to a possible sale. It confirms the facts of the company and prevents harm based on untruths. Due diligence can also be used to determine

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