Capital Budgeting Techniques

Introduction

It is difficult to choose a project even though it is the best preference among alternatives. In order to decided to pursue the decision of investment one should evaluate using different methods that are available and methods greatly influence decisions taken. For instance, when using non-discounting methods of capital budgeting, time value of money ignored whereas the discounted methods consider the time value of money. Thus, the choice may lead to different answers using one method or the other.

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Most of these firms are faced with various decisions which require huge investments of the company’s funds. The decisions the firms face include replacement decisions, expansions and diversification of operations. Any investment decision to be undertaken by a company will influence its growth in the short and long run as well as affect its riskiness. Capital investment appraisal techniques have changed over time because of various factors such as existence of multiple projects that are mutually exclusive, independent projects and contingent investment. Inflation rates and other complexities have made investment decision making or evaluation techniques change over time (O’Connell, 1999).

Capital budgeting techniques

The three (3) primary methods of Capital Budgeting are the Discounted Methods, Non-Discounted Methods and the Equivalent Annuity Method (Book of Accounting, 2010). The Discounted Methods of Capital Budgeting are the Net Present Value method, Profitability Index, Internal Rate of Return and Present Value Payback Method. The Pros of using the Discounted Methods are emphasizing the cash flows, recognizing the time value of money, assumes the discount rate as reinvestment rate and computing the real project return.

The Cons of using the Discounted Methods are requiring the costs of capital determination or using a discount rate, the NPV of various and different projects of competition may not be comparable due to differences in prices including the magnitudes of the said projects. In addition to cons, IRR or Internal Rate of Return or IRR assumes rate of re-investment and when the project includes earnings that are Negative during its life, the result is absolutely different rates of return (Eugene and Brigham, 2010).

On the other hand, the non-discounted methods of Capital Budgeting are Payback Period, Bail-Out Payback, Accounting Rate of Return and Payback Reciprocal. The Pros of non-discounted methods are the simplicity of payback in terms of computing and easy understanding, giving significant information regarding project’s liquidity and of course, the non-discounted method is considered as the good surrogate for risk. In line with this a quick or short payback period may indicate a less project which is certainly indicating a less project which is indeed risky.

The cons of non-discounted methods such as Payback Period are not considering the time value of money wherein all cash being received during the payback period is assumed to be equal of in terms of project’s analysis. Furthermore, there is more emphasis given on liquidity passably than the project’s profitability which means that more emphasis is distributed on investment returns. The salvage value of the project was not even given considerations and at the same time ignoring the cash flows that may even occur after the short-sighted payback period (Eugene and Brigham, 2009).

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Moreover, the Accounting Rate of Return advantages or pros are closely parallels with the concepts of accounting regarding the measurement of income as well as investment return; it facilitates the projects’ re-evaluation because of its data that is readily available from the records of accounting. In addition to pros, the method is considering the income which is over the project’s entire life as well as emphasizing and indicating the profitability of the project. The cons of Accounting Rate of Return are not considering the time value of money, the income computation including the book value was based on historical cost of accounting data wherein the inflation’s effect was ignored.

There is also a method of equivalent annuity which is used in evaluating the project. It is net present value divide by present value factor of annuity. This method works well where the net present value is positive. The pros of this method are to asses only those costs which are said to be very specific to projects having the same cash inflows and at the same time useful in terms of comparing the projects of investment having life spans that are indeed not equal.

The disadvantages of equivalent annuity method are the assumptions that are made. The disadvantages associated with this method include the treatment of inflation and nominal rate of interest.

In evaluating options, the company might also want to use NPV as a criterion. That is if the project has a positive net present value, then it is better of financing it. Although several finance practitioners had pointed out that sometimes IRR and NPV shows conflicting result, the study of Signh and Gaur concluded that “It must, therefore, be emphasized that when an evaluator has to reject or accept a project in a real life situation, IRR criterion does not conflict with NPVI criterion.

Indeed any one of the two would serve the purpose” (2004, p. 1643). These sometimes conflicting results, however, is due to the fact that IRR and NPV “have intrinsic differences between one another. The internal rate of return is considered to present the society while the net present value is considered to be present. The investor interest of the internal rate of return will vary as per source of financing. While the net present value remains constant so long as the discount rate is maintained. So, there should really be no confusion as regards the results of these two financial tools.

From the excel calculations using the two discounting methods none of the options is viable as they have negative net present value of $ 35,412 for option A and negative $ 63,595 for option B. This means using this criterion the projects should be rejected as they will cause the company losses.

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The net present value was arrived at by calculating cash flows of the project and discounting them using 9% rate given in the case study. Excel was used to calculate this net present value. However it can be obtained by using the following formula:

n

NPV = ∑(expected cash flow)/ (1+ discount rate)t – invested amount

t=1

If the value of NPV is found to be greater than zero only then will the project be undertaken.

Using the Internal rate of return also has a negative results by having IRR of 8% for all options, the net present value of the project, with the 9 per cent discount rate, is negative (Miles and Ezzell, 1980). The cost of capital estimation is a very important decision since it can impact all the criteria in evaluating the project: a higher cost of capital means lower present value of the cash flows generated by the project; and a higher benchmark to be compared with the IRR – the smaller the gap between IRR and the cost of capital, the higher is the chance of that project being rejected (Myers, 1974).

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Non-qualitative factors

Before making a final decision on the investment to undertake; various qualitative factors will need to be taken into consideration. The management should consider the issue of corporate social responsibility especially the effect of the project to he environment. They should consider whether the local community, environmentalist and the government will oppose the project now or a half way during the life of the project. This will affect the profitability of the firm in the long run. Other qualitative factors that should be condidered is like hood of escalating of inflation which will lead to employee strike. The entry of a competitor should also be considered for the purpose of knowing the effect of this on the project.

Conclusion and recommendation

The company should not undertake any option as they provide a negative net present value and IRR that is lower than discount rate. Based on the analysis carried out in relations to this project the project should be rejected because it provides a negative net present value and an internal rate of return which is greater than the cost of capital.

Whenever companies invest in certain capital projects they tend to see the amount of funds that are available to them. Once this issue has been resolved, they take a look at the options of the projects that are available to them. Independent projects are those projects which may be taken up individually or in combination with a set of other projects. The organization usually selects those projects whose aggregate NPV is positive. Whereas when we talk about mutually exclusive projects, we can see that these are those projects that have to be taken up exclusively from all the rest and cannot be selected in combination with the others. In the case of mutually exclusive projects, the one that has a positive NPV is usually selected (Jae and Shim, 2008).

List of References

Book of Accounting, 2010, Capital Budgeting Techniques. Web.

Eugene, F., & Brigham, J. 2009. Fundamentals of Financial Management. New york:South-Western College Publishers.

Eugene, F., & Brigham, M., 2010. Financial Management: Theory & Practice. New delhi: South-Western College Pub.

Jae, K., & Shim, J., 2008. Financial Management.London: Barron’s Educational Series.

Miles, J, & Ezzell, R., 1980, The Weighted Average Cost of Capital, Perfect Capital Markets and Project Life: A Clarification. Journal of Financial and Quantitative Analysis, 15: 719-730.

Myers, S., 1974, Interaction of Corporate Financing and Investment Decisions – Implications for Capital Budgeting. Journal of Finance, 29:1-25.

O’Connell, F., 1999, How to Run Successful High-Tech Project-Based Organizations. London: Artech House.

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