Free Essay On Capital Budgeting

Application of Financial Concepts in Multinational Companies

Introduction
Wal-Mart is a retail business operating a number of retail stores globally. The company’s operations are under three segments; Wal-Mart International, Wal-Mart USA, and the Sams Club. Its stores include discount stores, hypermarkets, supermarkets, cash and carry stores, warehouse clubs, supercenters, apparel stores, home improvement stores and retail websites, among other stores. It has about 11,000 stores in 27 countries and e-commerce websites operating in 11 countries. This paper explores the application of capital budgeting techniques at Wal-Mart Inc.

Capital budgeting involves the evaluation of long-term investment projects in order to assess their viability (Madura, 2007). Capital projects require a large capital outlay and are irreversible in most cases (Madura, 2007). This requires critical analysis and evaluation of their profitability before the company decides to invest in such projects. Wal-Mart’s capital projects include the purchase of fixed assets, acquisition of other firms, opening new branches, among others. According to the CEO of Wal-Mart, the company is shifting its focus to e-commerce as a way of improving customer satisfaction. In recent years, investment in e-commerce websites has become a major part of the company’s capital project.

Capital budgeting techniques

The conventional capital appraisal methods include the NPV, IRR, profitability index, accounting rate of return, among other measures. Net present value is the most widely used method (Madura, 2007). It is the difference between the present values of costs and benefits of a project. The company can determine the NPV of a project by first determining the expected cash inflows and cash outflows. The cash flows are then discounted at the rate of the company’s weighted average cost of capital (Madura, 2007). The decision criteria is that projects with positive NPVs are viable hence are considered for investment. On the other hand, projects with negative NPVs are not viable hence they are rejected. In case of competing projects, the company should select the project with the highest NPV. Internal Rate of Return is the discount rate at which the NPV of a project is zero (Brigham and Ehrhardt, 2007). It is, therefore, the minimum return a project must generate for it to secure funding from the company. The criterion, in this case, is that a project is accepted if its IRR is more than the company’s average cost of capital. For multiple competing projects, the company should select the one with the highest IRR (Brigham and Ehrhardt, 2007). Both methods are widely used since they consider the time value of money by integrating the aspect of risk in capital budgeting. In addition, they use all the cash flows generated throughout the project’s useful lives. NPV is preferred to IRR especially when evaluating a single project (Brigham and Ehrhardt, 2007). It gives an absolute value rather the relative value given by the IRR. In addition, the IRR techniques may lead to multiple values especially when the project has unconventional cash flows.
The company can also use traditional investment appraisal techniques such as the accounting rate of return and payback period. Accounting rate of return gives the annual return on the initial investment of the project. Payback period gives the duration the project will take before generating adequate cash flows to recover the initial cost of the investment (Baker and Powell, 2009). These techniques are constrained by the fact that they do not consider the time value of money. Payback period also ignores the cash flows generated by the project after the payback period, and this may be misleading especially when a project makes most of its cash flows at the later stages of its useful life (Baker and Powell, 2009).

Wal-Mart’s capital budgeting strategies

The major capital projects in the company have been on expansion through acquisition and opening new stores. The company requires a return on the capital projects and uses methods such as the NPV and the accounting rate of return to assess its investments. In the fiscal year 2015, Wal-Mart plans to incur between $11.8 and $12.8 billion in capital expenditures (News.walmart.com, 2015). The plan involves adding its net global retail square feet by between 33 and 37 million. About half of the total planned capital expenditure will go to its largest segment, Wal-Mart US (News.walmart.com, 2015). The company’s mantra over the last years has been to expand and expand by creating a number of supercenter stores. However, this trend is changing as the current CEO, Doug McMillon, announced during the annual meeting with its investors. The CEO stated that the company will be reducing its capital spending in discount retail stores especially in the US (Wahba, 2014). This is because the company has not experienced adequate sales growth in its US stores. The sales of consumables and general merchandise in the US stores have declined and remained under pressure (Wahba, 2014). The stores have experienced less customer traffic thus leading to an increase in out-of-stocks. The company did not report growth in comparable sales for six consecutive quarters.
The company has, therefore, shifted its capital spending to the development of technology and e-commerce. E-commerce is the company’s top priority as it seeks to improve customer convenience by enabling them to compare prices easily and offering them a wider assortment. The company also announced that it will concentrate on the expansion of Neighborhood Market stores in the US (Wahba, 2014). It plans to open 200 new Neighborhood market stores in the US in the fiscal year 2015. The stores are becoming popular since they are easier to reach, unlike its supercenters.
The company uses capital budgeting techniques in determining where to incur capital expenditures. The weak growth in US supercenters implies a reduction in the cash inflows from the stores. It also shows that the net sales and income from the sales are declining. These indicate that the return on the capital expenditure on such stores is falling. The expected NPV and IRR on the new supercenter stores are declining due to the low sales of goods. In order to reduce losses on such investments, it is necessary to cut capital spending on supercenters. This informed the decision of the Wal-Mart to reduce capital investment on new Supercenters in the US. According to the CEO, the company will build half as many supercenters built in the previous year (Wahba, 2014).
Wal-Mart’s decision to increase capital expenditure on e-commerce and Neighborhood Market stores is informed by the growth of revenue from the two areas. The e-commerce platform and the Neighborhood stores are growing and raising more revenue than the supercenters whose sales are at doldrums. Evaluation of investments in these two areas, therefore, indicates higher NPV, IRR and accounting rates of return than in the investments in supercenters. Therefore, the company’s decision is informed by the capital budgeting techniques. In this, the capital rationing concept is applied by Wal-Mart. Under capital rationing, the company increases capital spending to projects with higher NPVs, IRR and rates of return while reducing the capital spending on projects with lower returns. The goal of capital budgeting is to ensure that the company invests in projects that increase shareholders’ wealth.

Bibliography

Baker, H. and Powell, G. (2009). Understanding financial management. Malden, MA: Blackwell Pub.
Brigham, E. and Ehrhardt, M. (2007). Financial Management: Theory & Practice. 12th ed. New York: Cengage Learning.
Madura, J. (2007). International financial management. 9th ed. Mason, Ohio: Cengage Learning.
News.walmart.com, (2015). Wal-Mart announces $11.8 to $12.8 billion FY2015 global capital expenditure plan. [online] Available at: http://news.walmart.com/news-archive/2013/10/15/walmart-announces-118-to-128-billion-fy2015-global-capital-expenditure-plan [Accessed 25 Apr. 2015].
Wahba, P. (2014). Wal-Mart CEO says ‘no excuse’ for weak U.S. growth, lays out fix-it plan. [Online] Fortune. Available at: http://fortune.com/2014/10/15/walmart-doug-mcmillon-investor-day/ [Accessed 25 Apr. 2015].