Capital budgeting or what is sometimes referred to as investment appraisal is a management process which involves evaluating of the investments of the company to determine where there are viable or not and thus determine whether to accept the project or reject it all together. Some of the investment decisions that has to be made by the companies include replacement decisions for the company's fixed assets such as machinery, introduction of new products to the already existing products produced by the company, engaging in long term investments such purchasing shares of other companies among other investment (Ross, Westerfield & Bradford, 2006).
Essentially it is the requirement of the management to pursue all the investments options that are available to the company in order to create wealth of the owners of the company or the shareholders but the resources available to the company are not sufficient and thus the management are required to conduct project appraisal in order to determine the projects that would bring the maximum return to the investors (Shim & Siegel, 2008). It is important for organizations to engage in capital budgeting before they invest in a certain projects because of the enormous resources required to start the project. Incase the project fails there would be huge losses that would be incurred by the firms. Another reason is that the investments decisions that peoples make are not easily reversible, the projects that the company invest in have a long term implications on the operations of the organization and lastly due to the fact that the investments involves risks and uncertainty to the firm and thus the organization evaluate the suitability of the investment to the firm through carrying out capital budgeting. There are various methods that are used in capital budgeting which are classified into two; traditional methods and the discounting methods.
Traditional methods of capital budgeting include payback period and the Average rate of return which the discounted methods of capital budgeting include Net Present Value (NPV) and Internal Rate of Return (IRR). Every method of capital budgeting has its weaknesses and strengths and thus no method is superior or inferior to the other (Brigham & Houston, 2008). Traditional methods of Capital budgeting Payback Period Method The pay back period has been used as a traditionally to evaluate the worthiness of a certain investment portfolio. Pay Back Period is a financial metric that concerns itself in ascertaining the period of time that a project shall take to pay back the investment that has been committed into it. Pay back period is considered one of the easiest approaches to capital budgeting as it is easy to compute. This explains why this method has been used in the traditionally in capital budgeting.
It is a valuable asset in budgeting as it shows the time that the project shall take to ensure that it breaks even. Investments with a lower pay pack period are considered to be better compared to those with longer pay back periods. This is because shorter pay back periods indicate that the investor's money shall be recovered within a short period of time. Merits of Payback Period Method Payback period is hailed for its simplicity to arrive at the final period. It does not therefore demand for technical knowhow when arriving at the final answer which basically answers the period that it shall take to arrive at the final period of time that shall be taken to recover the investment. An investment of ? 2500 with an annual return of ?500 shall take 5 years to pay back the investment.
The pay back period therefore is 5 years Demerits of Payback Period Method Despite the ease of use of this method, the method has many demerits. To begin with it ignores the time value for money and thus it assumes that today's 1 pound shall be equivalent to 1 pound ten years form now (Helfert, 2001). Secondly, it is evident that payback cannot be calculated if the positive cash that flows in to the business does not outweigh the outflows of cash. Thirdly, the method assumes consistent flow of cash or consistent growth which is not always the case. Where cash flows fluctuate, various payback periods shall be arrived at.
The fourth weakness is that the method ignores the cash flows that come after the pay back period. It may therefore lead to adoption of the lesser feasible project that may have lower payback periods. Example Suppose that the capital outlay of an investment is $ 15,000. Assume further that the cash flow generated by the investment is for the first five years is 7, 000, 6000, 3000, 2000 and 1000. The formula for calculating Payback Period= X + (A/B) Where: X = the period before the final back period A= Total amount that is remaining to be paid back during the beginning of the payback period B= amount paid back during the whole period of paying back. Solution Payback Period = 2 + 2000/6000 2 years 4 months Average Rate of Return (ARR) The method is also known as Average rate of return and also ignores the concept of time value for money.
ARR is calculated in percentage and projects that meet the company's desired rate of return are accepted. High ARR shows that the return is good and thus such projects should be preferred. Merits of Accounting Rate of Return Firstly, the method is simple to understand and use. Secondly, the method recognizes profitability of a project thus taking into account the future incomes of a project that are ignored by the pay back period method.
Thirdly total earnings that are to be realized in the lifetime of the project are considered. Demerits of Accounting Rate of Return A major weakness with this method is that it ignores the time value of money. The method also lacks in accuracy as it only uses income data instead of cash flows which limits its accuracy as far as capital investments are concerned. Average Rate of Return (ARR) is also referred as Profitability Index (PI). ARR = Profitability of the firm/ Total capital outlay Example Assume that the capital outlay of an investment is $ 15,000 and that the profits generate for the first five years is $ 8000, $ 2000, $ 1000, $ 3000 and$ 4000. ARR = Profitability of the firm/ Total capital outlay ARR = (8000+ 2000+1000+3000+4000)/15000 ARR= 18000/15000= 1.
2 Internal Rate of Return (IRR) This method of discounted methods of project appraisal equates all the net present values of a project's cash flow to zero. Projects with higher rates of return are desirable to investors. Merits of the Internal Rate of Return This method is easy to compute and to understand and make inferences. This makes it easy to be used by decision makers that may not possess accounting knowledge.
The method also tells whether an investment increases the value of the organization and finally it considers the time value of money (Finnerty, 2007). Demerits of the Internal Rate of Return The method however is weakened by the fact that it utilizes estimates in order to make a decision. The method may be misleading if used for mutually exclusive projects and when there is capital rationing. Internal rate of return takes into consideration time value of money that is the cash flows are discounted to take in to account the time value of money.
It can be said to the discounting rate that results to NPV being zero. In the formula below, R is the internal rate of return (IRR) Example Suppose that the Cash flow generated by the Project is (6,000), 1,000, 1,000 4,000 1,000, 1,000 in the first 5 years. Required: calculate the IRR of the project. Assume the cost of capital is 8 %. Net Present Value (NPV) The net present value methods ascertain the present value of future net flows of cash of an investment after subtracting the financing costs. This method advocates that whenever the present value is positive, the project is worth pursuing and vice versa.
The project with the highest NPV should be chosen as the most viable project (Brigham and Houston, 2009) Merits of the Net Present Value Method This method is hailed for a number of reasons. To begin with, the method ensures that only projects that shall guarantee income to the net value of the company. The method also considers all the cash flows attributed to a certain project. The method also considers the time value of money while at the same time it considers the risks of the future cash flows. Demerits of the Net Present Value Method This method however has a major weakness in that it uses estimates rather than actual inflows to determine the net present value of the project.
Another weakness is that it expresses its answer in form of a currency as opposed to percentages. NPV = Discounted Cash Flows- initial capital of the investment Example Assume that the initial capital of the investment is $ 15,000 and the Cash flows generate per year for five years is $ 7,000, $6,000, $3000, $2000 and $ 1,000. Assume that the cost of capital is 10%. Required: calculate the Net Present Value of the investment.
Solution Sum of Discounted cash flow is given by (6363+4959+2254+1366+621) = $15563 Thus NPV = $ 15563 - $15000= $ 563 The objective of all entities is to make a profit now and the years to come. When making decisions that affect an entity, it is very important to ensure that these decisions take into considerations the qualitative and quantitative aspect of issues of the firm. It has been realized that short term decisions are considered to be relatively simple regarding the quantitative ideas as coompared to long term decision under the same circumstances (Hammer 2009). The long term decisions constitute of two dimensional perspectives, the timing and the magnitude. For instance the analysis of the firm's cash flow addresses the timing dimension whereas issues such as the experience, intestinal fortitude and information concentrate with magnitude. When addressing the discounted cash flow of an entity, a common phrase of referring to the dollar is constantly used, it is assumed that a dollar made today is of significant essence compared to that dollar that will be made tomorrow.
This is due to a dollar in the future being accredited a lower value than today's dollar (Hammer 2009). The determination of the discount cash flows (DCF) analysis employs a number of steps. For instance, it should be noted that for the right discount rate to be identified, some of theses key figures should be noted (Courier & Berry 2010). A higher discount rate is equated to a lower present value and vice versa. Therefore it is logical to state that greater risks do command greater returns, therefore, greater risks is equal to higher discount rates.
When discounting the cash flows in the future by employing a specific hurdle, a comparison should be given between the present values being experienced by the firm in terms of cash flows to the investment. This implies that if the present inflows of the firm are higher, compared to the present value of outflows, then the investment is promising and acceptable. But if the present value inflows of the firm are lower than the present outflows of the firm, then such an investment is not acceptable. This therefore implies that the NPV = PV inflows - PV outflows. From the information presented by (Carra, Kolehmainenb & Falconer 2010), it is clear that the present value of an entity tends to compute the present value of future single amounts by the application of a specific discount rate. Similarly, the future value computes specific future amounts by applying specified discount rates.
The rate in this case is used to compute discounts that are specifically required in the conversion of present value to future values or the vice versa. It should be noted that the present value, the future value and the rate demand for equal and fixed streaming of cash flows and thus can not be relied entirely when making long term future firm decisions. According (Hammer 2009) the NPV is utilized in computing the net present value of a set of future entity's cash flows that are can not be predicted. Therefore, if the NPV is greater than zero, then the firm is heading in the right direction but if the NPV is less than zero, then such an investment should be shunned.
When applying this strategy, the discount rate is also very critical (Courier & Berry 2010). The relevance of the findings from the report tries to indicate that all the cash flows should be computed at the end of the financial year. In the payback period, (the period taken by an entity in recovering what it has invested in a given project), the DCF is normally not used in its calculation. Profitability index which is a prioritizing element is used as an investment tool from a group of investment alternatives (Courier & Berry 2010).
Decisions made in strategic investment often present a number of opportunities that vary in intensity. These opportunities are often accompanied by a wide range of potential alternative outcomes which constantly depend on outcomes that are reliable to initial investments outcomes that have been witnessed before. The payback method used in evaluating this is termed to as a good indicator since it takes into consideration of the risks that are involved in an investment project and especially those that are expressed in the form of the economic lifespan of the investment project (Carra, Kolehmainenb & Falconer 2010). The calculations in the discounted payback calculations often allows the period of the cash by the application of an interest rate that is negative to that of the future flows thus bringing them to the PV. The discount indicators applied in this case are often applicable to all future cash flows. In the NPV, a specific criterion of computing for the rates is often chosen to compute the present value, the higher the PV is, and the more attractive the financial investment will be.
If the rate used is close to the rate of returns expected by the shareholders, then the NPV is employed as a reliable indicator of the opportunities available for the investment. Constantly, the internal rate of return (IRR) is employed as an alternative rate of return to the anticipated cash flows till such a time as to when a specific rate that is capable of generating zero returns in NPV is arrived at. Despite the IRR being a very popular criterion for NPV determination, there are a number of flaws and problems that do accompany his strategy. The NPV can be transformed into ratios or percentages through the division of it with the original investment value; this is what is termed to as the profitability index (Carra, Kolehmainenb & Falconer 2010). When investments are started there are a number of risks that they are faced with, this may vary from those presented by the external environment which are also accompanied by those from within the entity. In a number of instances, it is very important for those involved in such decisions to ensure that all the decisions made are arrived at after thorough considerations of how they will affect all the entity's stakeholders.
Generally, the risks can either be categorized into financial risks and operational risks (Hammer 2009). The conclusions that are arrived at are of great relevance as they help in establishing the exact viability of a project. It is form these conclusions that the final viability of a project can be ascertained and an investment decision made. The conclusions therefore assist in ensuring the resources that are scarce are invested in the best ways such that the investors gets the best deals for a return on their investments.
In conclusion the methods that have been analyzed in this paper as are useful in determining the success or otherwise of an investment. Capital budgeting therefore is an important tool for effective decision making in an investment.