In long-term decision-making, one of the important areas a firm must consider is investment. Investment is the committing of some of the firm's funds to acquire capital assets by buying of assets such as buildings, machinery, and land, just to mention a few, in anticipation that they will generate a greater income than the committed funds. So as to make these decisions, it is very vital for a firm to make an evaluation on the amount of the inflows and outflows of funds, attached degree of risk, the duration of the investment, and the price of acquiring funds(Brigham, & Houston, 2007 p 34). In assessing whether the capital cost of a particular project will bring forth benefits to the firm or not, an Investment Appraisal, which is also referred to as Capital Budgeting is used to conduct the evaluation (Vishwanath, 2007 p 14). This generally means assessing the attractiveness of the investment proposal.
Capital Budgeting methods are appropriate to all decisions outlined in the investment planning process. There are different appraisal methods that a firm can use. It is essential for an organization to understand all the methods i.e.
their assumption, limitation and their possible use. This will give a firm a wide array of methods to use and also it will increase their understanding in decision-making in investment. This will greatly facilitate the process of decision-making in investment program and also to single investment projects(Vishwanath, 2007 p 174).There are many criterions that AP Plc can use to analyze and select capital investments and projects.
However, making such a decision may be quite difficult because of inconsistency in discounting rates, risk, and uncertainty. In addition, some of this capital acquisitions and projects that AP plc wants to undertake will involve numerous variables, which may yield different results. For instance, determining cash flows associated with these capital acquisitions will involve estimating the required working capital, determining expected rates of inflation, project risk, disposal values, as well as tax considerations (Brigham, & Houston, 2007). Therefore, an understanding of the existing markets is a must, in order to estimate the capital acquisitions projected revenues, review the economic impacts of the capital acquisitions, and establish the project's life cycle (Brigham, & Houston, 2007).Considering that these capital projects that AP plc intends to undertake involves production, the Firm must consider the associated operating costs and overheads, start-up costs, and related capacity utilization. Accordingly, capital investments cannot be analyzed by merely looking at the numbers; this is investment discounted cash flows.
However, all relevant variables and results must be considered within a systematic hierarchy before a decision is made. Like any other firm, AP plc will want to invest in projects that will maximize present value.Net present value Given that these capital acquisitions will offer benefits into the future, we can estimate the present value of these future benefits by discounting the future cash flows of the capital acquisitions to the present (Finkler, 2005 p 72). It is advisable that AP plc only invest on those capital acquisitions that show a positive net present value, this is, the expected cash inflow present value less the present value of the capital expenditures required to acquire the items. Net present value will be a measure to determine those capital acquisitions that increase the firm's value (Vishwanath, 2007 p 184).
If the present value of the benefits (inflows) exceeds the present value of outflows, then the net present value of the investment is positive. A capital investment with a positive Net present value shows that it a viable project.Internal rate of returnWhen deciding on the mentioned capital acquisitions, it will be important to determine the most probable rate of return of the investment. Internal rate of return for the mentioned capital acquisitions will be the discount rate that forces the investments' net present value to equal zero (Brigham, & Houston, 2007).
This discount rate that equates the capital acquisitions to the present value of its inflows is very important because it shows the investments' expected rate of return (Park, 2010 219). If the expected rate of return exceeds the cost of investment used to finance the acquisitions, it shows there is gain (Sharan & Vyuptakesh, 1997 p 80).In excel, net present value is solved by the formula; IRR (value, guess), where values represents all inflows and cash outflows. The guess is just a guess of the best rate of return.Project A has a higher Internal Rate of Return, indicating that it will earn more on the initial investment. The Company will be more comfortable ranking the projects by their internal rates of return rather than their NPV irrespective of their sizes.
The time taken for an investment to recover the initial capital invested is referred to as payback (David Kazmer 2009, 18). Pay back period is calculated by dividing the cost of the initial investment by the rate at which the project recovers the initial investment.If AP Plc was to consider the project with the shortest pay back period, Project A will be the choice.The effect of increase in cost of capital on NPV Net Present Value actually improves with increase in discount rate.The effect of decrease in cost of capital on NPV Net Present Value decreases with the decrease in discount rate.The NPV effect of a changing discount rate on relatively long term project and short-term projects The Net Present Value of a relatively long-term project is usually more susceptible to changes in the cost of capital compared to the short term project given to the possibility that it is expected to yield higher percentage of cash flows in the distant future (Sharan, 2000 p 68).
This is because the Net Present Value is calculated by discounting future cash flows, and the process of discounting the future cash flows essentially compounds the rate of interest over time. Thus, such an increase in the rate of discount will have a more impact on a long term project's cash flow, for example a nine Year project, than on a shorter project's cash flow for a project with a one Year lifespan. Net Present Value of long-term projects is therefore more sensitive to changes in the cost of capital as compared to short-term project's NPV. (g) How the change in the cost of capital affect the project's IRR Internal rate of Return (IRR), which is closely linked to the net value (NPV), is an investment profitability measure. In an investment, the IRR is the return rate which makes the NPV of an investment to be equal to zero when it is used to discount an investment's future cash flows. This suggests that when using IRR to discount future cash flows of an investment or a project, their Present Value will precisely be the same as the initial investment amount (Sharan,& Vyuptakesh, 1997 p 88).
The IRR gives the actual rate of return that will be generated on the initial investment if the predicated cash flows occur. In calculating the IRR the capital expenditure or the discount rate is not used This discount rate that equates the capital acquisitions to the present value of its inflows is very important because it shows the investments' expected rate of return (Park, 2010 219). If the expected rate of return exceeds the cost of investment used to finance the acquisitions, it shows there is gain.Therefore, a comparison is made and if the IRR exceeds the opportunity cost of capital (rate of return that can be earned if the same capital was invested in another project), the project is accepted.
Therefore, an increase or decrease in cost of capital does not have a direct effect on the projects IRR (Werner & Stoner, 2006 p 536). Comparing the effectiveness of the NPV method with that of the IRR methodNet present value is an approach that is used determines which capital acquisitions that increase the firm's value. The method calculates the present values of inflows and the present value of outflows and compares them. If the present value of the benefits (inflows) exceeds the present value of outflows, then the net present value of the investment is positive. A capital investment with a positive Net present value shows that it a viable project. Though similar to the Internal Rate of Return method, Net Present Value approach does not calculate the exact rate of an investment's return but instead computes the exact gain by which a capital investment exceeds, or fails to meet the anticipated rate of return.
In other words, the NPV of an investment will be zero if it yields a rate of return that is exactly equal to the opportunity cost of invested capital. Therefore, the Net Present Value approach simply measures how better an investment does than a specific hurdle rate of an opportunity cost. However, this method does not calculate the rate of return that the investment actually gains.Internal Rate of Return approach also has some major drawbacks. One major limitation is that the method assumes that all cash inflows earned by the investment project are re-invested at the same discounting rate that the venture earns (Vishwanath, 2007 p 174). Another major weakness of IRR method is that it can give some flawed results if the investment being analyzed does not give an even or a conventional cash flows pattern.
NPV does not suffer from any of the drawbacks of the payback as is the case with IRR method. For this reason, the method is highly regarded by the financial experts in making financial decisions.IRR is still useful for determining the exact rate of return of an investment, but NPV has non of the problems that IRR method has with unusual investments.
