Essay (20 % of course grade)
Students should select one of the topics from the list below (or an alternate topic preapproved by the instructor. The essay is due in the individual\’s Assignments Folder as indicated in the Course Capital budgeting , Net Present Value, and other decision tools
Capital budgeting , Net Present Value, and other decision tools
Guide/Schedule.
The essay should demonstrate a student\’s ability to integrate and synthesize course concepts with selected readings to communicate his/her understanding of financial management concepts their application in organizations. The essay should also demonstrate a student\’s ability to communicate as a manager. This includes proper writing style, organization, grammar, and spelling, as well as integration of course-related material. The writing style must follow the Publication Manual of the American Psychological Association , 5 th edition. Citations for online sources should include the online address (URL) and access date as well as the citation for the specific reference.
Research for the paper may be conducted online using the UMUC online library as the primary source. Do not use abstracts, use full-text articles. Publications that may be relevant for the topics listed below include: Strategic Finance, The Journal of Business Finance and Accounting, CFO Magazine, Nonprofit World, Harvard Business Review, or other accounting and financial journals.
The paper should:
• Be based on your reading and research relevant to the topic.
• Be 7 – 10 double-spaced pages, plus appendices, exhibits, and references.
• Include a one-page Executive Summary immediately following the title page that includes a statement of the major issue(s) and your conclusions and specific recommendations. The content of an Executive Summary is similar to an abstract.
• Properly cite reference sources: these may include course material, information from magazines, journals, and online sources. All reference sources must have a publication date within the last three years. Students who wish to use an older source publication should contact the instructor with the request and reason.
Essay Topic List
1. Capital Budgeting, Net Present Value, and other Decision Tools – Write an essay that analyzes the pros and cons of the commonly used measures ( NPV, IRR, PI, MIRR, DPB) and come to a conclusion based on the literature that you surveyed as to which methods are theoretically correct and those popular. Emphasize real-world practices of capital budgeting methods, including project approval processes. Synthesize the discussions in published research or survey articles (Text Material: Parrino – Chapter 10).
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Finance: Capital Budgeting, Net Present Value and Other Decision Tools
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Abstract
The main objective for existence of any organization is to make returns on its investments. However, good investment depends wholly on the success of the decisions made. A wrong decision, especially, which involves large capital outlay, for instance in capital investment, can result in major losses or total closure of firms. In order to make decisions that are in line with short term and long-term company objectives, managers use capital budgeting tools when appraising their investments.
The choice of a capital budgeting tool depends on a number of factors, which includes the amount of capital, its simplicity and ability of the tool to take care of the unforeseeable future risks associated. Many capital budgeting techniques that can be used by managers to appraise future investment are available. The most common budgeting investment appraisal techniques that this paper analyzes are the net present value, internal rate of return, modified internal rate of return, profitability index and discounted payback.
The analysis of the above budgeting techniques showed their weaknesses and the varying degree of applicability. The paper established that the profitability index was the widely used method of investment appraisal owing to its strengths, which include its ability to take care of unforeseeable future risks and time value for money. However, the other methods remain in use owing to certain factors such as the amount of capital investment.
Introduction
The main objective of any organization is to make profits and give good returns to their shareholders. However, the performance of any organization largely depends on the decisions that management make. Whereas some decisions might be easy to make, some decisions that involve projects that demand massive capital investment need to be assessed in a professional way.
Once a project has been identified, a decision has to be made, whether to invest in it or not. Such financial decisions are often done using financial tools such as payback period, profitability index, internal rate of return, modified internal rate of return, discounted payback period and net present value. However, these financial decision tools have their pros and cons, which limit the use of some of the tools. The following are the pros and cons of the financial decision making tools and the frequency of their use.
Capital Budgeting Decision Tools
Capital budgeting refers to a decision making process where a firm evaluates the potential long-term investments it needs to invest (Zenwealth.com, 2015). Normally, it is expected that the long-term projects are able to generate cash flows over some time. The analysis of the expected cash flows from the future project will determine if it will be accepted or rejected. The decisions to reject or accept can be analyzed using the following capital budgeting decision tools.
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Profitability Index (PI)
- Modified Internal Rate of Return (MIRR)
- Discounted Payback (DPB)
Net Present Value (NPV)
When projects have different cash flows, different service lives and varying costs, it is imperative that the time present value of money must be put into consideration (Cliffsnotes.com, 2015). The net present value is used to analyze such projects. Net present value is a discounted cash flow technique that utilizes the amount as well as the timing of cash flows in any future project. In order to employ this technique, it is important to know the expected internal rate of return of the company, the cash flows and the project cash out flows. The required rate of return of the company is used in calculation of NPV as a discount rate. NPV is evaluated using the formula:
NPV = Net Present Value of Inflows – Net Present Value of Outflows
Pros and Cons of NPV
Pros
The net present value is a commonly used and effective method of appraising investments. Its effectiveness comes from the fact that the method employs discounted cash flow analysis where the discounted rate helps to take care of future uncertainty associated with future cash flows (Investopedia, 2012). The discounted rate is an imperative part of net present value since it represents various forms of the company undertaking investment decisions. For instance, it may represent the cost of using company internal funds or cost of borrowing capital for investments (Extension.iastate.edu, 2015).
Cons
Although net present value is a commonly used financial appraisal tool, it is not without its drawbacks. The major drawback of this method comes from the lack of computation of the rate of return. The ability to reject or accept a project is purely based on the calculation of the present value. This draw back has led many analysts in preferring adjusted rate of return instead of NPV (Kimmel, Weygandt & Kieso, 2011).
Internal Rate of Return
While it employs the concept of present value, internal rate of return evaluates the interest that a future project is likely to accrue at present value of zero (Schmidt, 2015). At the present value of zero, the value of inflows is the same as the value of the proposed investment. In order to evaluate IRR, an iteration process is used where the NPV = 0. The formula for calculating IRR is given as 0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn /(1+IRR)n (Investinganswers.com, 2015). Where n= the period in which the cash flows occur, P= the respective cash flows.
IRR is best suited in appraisal of projects such as private equity investments and venture capital that have multiple investments and a single cash flow at the end of the investment (Investinganswers.com, 2015). Whether a company can use IRR or not is based on its advantages and disadvantages. However, a project should only be accepted if the calculated internal rate of return matches the target set by the management (Accountingexplained.com, 2015).
Pros
The use of IRR makes it possible for investment managers to rank the feasibility of projects based on the internal rates of returns rather than their present value. The use of internal rate of return makes it easy to measure the feasibility of projects; the formula allows the management to compare one project with the other (Small Business – Chron.com, 2015).
Cons
One major disadvantage of use of internal rate of return is the reinvestment assumptions. The evaluation of project based on IRR makes an infeasible assumption that immediate cash flows are reinvested at the IRR rate, which does not happen always. In addition, the use of IRR is only possible with projects that have initial cash flows and subsequent cash flows. The other major shortcoming of IRR is its inability to measure the size of investment in addition to its likelihood to favor huge investments (Investinganswers.com, 2015). For instance, IRR is likely to accept 1$ with returns of 5$ while rejecting a similar investment with returns of 2$. Finally, IRR does not consider the cost of capital and this makes it hard for managers to predict projects with varying durations.
Profitability Index
Profitability index, also termed as cost-benefit ratio is a capital budgeting tool that uses discounted technique in evaluating the viability of an investment. According to (Borad & author, 2015), profitability index is defined as the ratio of discounted cash inflows to the cash out flows of an investment. (Borad & author, 2015) further points out that, since the cash inflows serve as benefits of the investment and the initial investment serve as cost, profitability index is the reason it is sometimes termed as cost-benefit ratio. Profitability index can be evaluated using the formula below:
Adapted from (Borad & author, 2015)
The profitability index (PI) ascertains the monetary cost of a project and compares it to the expected benefits in monetary terms. In computing the present value of the benefits of an investment, compared to its cost, the project is approved if the value of PI is greater than one, otherwise it is rejected (Wilkinson, 2013). When the value of PI is equal to 1, it means the expected future returns will be equal to the cost of investment, and no profits shall be made. However, the expected future returns on an investment are higher than the cost of investment if the value of PI is greater than 1 and that is why the projected is accepted. On the other hand, a negative PI signifies an investment that falls short of expected results and the one that is likely to lead to a loss (Investments, 2015). The profitability index has its own advantages and disadvantages.
Pros and Cons of PI
Pros
The PI is much easier to understand and offers more communication compared to net present value. The other advantage of this capital decision technique is that it is an imperative way of evaluating projects especially when funding is limited. The use of PI comes in handy in such a circumstance that warrants capital rationing. PI is simple to calculate besides it provides information regarding liquidity of a firm and the risk of the future cash flows (Wilkinson, 2013). Finally, PI takes care of all future cash flows of an investment and provides an assessment on the time money value of a project, showing whether an investment increases the value of a firm or not (Peterson-Drake, 2015).
Cons
The main demerit of profitability index is the difficulty of using the interest/discounting rate. In addition, the use of profitability index needs an estimate of the cost of capital and the method may not be efficient if used to evaluate multiple mutually exclusive investments (Peterson-Drake, 2015).
Modified Internal Rate of Return
The major assumption of the internal rate of return is that the cash flows shall be reinvested at the internal rate of return. However, this may not be the case since the reinvestment rate may vary than the internal rate of return, thus skewing the results. The modified internal rate of return is an improvement of the internal rate of return, which was devised in order to address the shortcomings of the internal rate of return method.
The use of internal rate of return involves three basic steps that when utilized well, it shall provide the most effective capital budgeting decisions. The first step is discounting of the funds committed to a project to the present in such a rate that fairly reflects the investment risk. Secondly, the cash flows are compounded forward with the exclusion of the investment and within the investment chosen period. Finally, the internal rate of return is evaluated. It is worth to note that the re-investment rate represents the future opportunities, where risks equal the investment risks of the future project.
Pros and Cons of Modified Internal Rate of Return
Pros
There are many reasons why project analysis may opt to employ MIRR rather than IRR. While IRR takes into consideration investment impacts and changing reinvestment rates, MIRR allows both the reinvestment rate and finance to be associated with inflows and cash flows during project evaluation (Icpas.org, 2015). Through MIRR, a company is able to know whether the investment is increasing the company value or not, unlike NPV or IRR.
While NPV and IRR have significant drawbacks in form of timing, ranking and problems of size, MIRR provides a way of assessing the risks associated with future inflows, cash flows and time value for money. In summary, MIRR gives a much better realistic view on the reinvestment of free cash flows.
Cons
Just like other capital decision tools, MIRR has its own disadvantages. When the method is used in mutually exclusive projects, it may lead to incorrect decisions (Borad & author, 2015). Most managers do are hesitant in using cost of capital and financing rate, which may skew MIRR decisions.
Discounted Payback (DPB)
The discounted payback method is an investment appraisal tool used by financial mangers to determine how quickly the cash flows of the investment can meet the cost of capital (Peavler, 2015). By discounting each cash flow, the method takes into consideration the time value for money. The major difference between the discounted payback and the payback period method is that DPB uses discounted cash flows as the interest rates and the particular year in which the cash flow occurs. This method has its pros and cons just like any other capital decision tool.
Pros and Cons of DPB
Pros
The major advantages of DPB are that is gives an estimate on the time it can take an investment to realize the initial capital. DPB also since it uses discounted cash flow technique, this method gives a better estimate of the time it can take an investment to recover initial investment when compared to payback method.
Cons
The efficiency of discounted payback method is reduced in the circumstance that the cash flows are overlooked. The other drawback of this method is that it needs an estimate of the cost of capital in order to evaluate the payback in addition to exudin…………………………………………………………………………………………………….
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References
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