Capital Budgeting Decisions and Kinds of Investment Appraisal Methods - Article Example

Capital Budgeting Decisions and Kinds of Investment Appraisal Methods Capital budgeting decisions have always been crucial for companies because theyeventually result in success or failure of business. If the history of businesses is explored, it will be found that poor investment decisions are the result of poor resource management. During 1880-1914, the investments in mining industry were high despite the high risk in this business. However, most of the companies failed in Sudan because of the deficient information available for making investment decisions.1 Sometimes, even if the information is available, companies make investment decisions based on traditional quantitative investment criteria. According to Kaplan and Atkinson, most of the U.S organizations making decisions based on traditional criteria have been unable to evaluate the potential options such as computer aided manufacturing.2 Since the resources available to an organization are very limited therefore, poor resource management may lead the company to the brink of failure, regardless of the nature and size of business. Therefore, instead of making decisions based upon calculation on the back of envelope, businesses have to consider various factors. The method of investment appraisal is used to analyze whether a project is feasible for an organization or not. Such investment decisions could be very small decisions such as purchasing machinery for the company or these could be large decisions such as investing in new product development etc. The primary methods that can be used for investment appraisals include Payback Period, Net Present Value, Internal Rate of Return, Accounting Rate of Return and Profitability Index.3 Since all of these methods might have limitations, therefore, investors have to be very careful whilst opting for any method. It is very important to note that the businesses do not only pick up an investment appraisal method to evaluate the investment, because apart from the appraisal method, there is a complete appraisal process that needs to be carried out. The investment appraisal process starts from the identification of objectives. Through the process of identification, the aims of making investment are highlighted and the primary purpose of investment is to seek future income streams from the investment. Investment appraisal methods help to assess the future income streams against the total expected cost of investment. There are primarily four distinct stages of investment decision method including Origination of proposal, project screening, analysis and acceptance and monitoring and review.4 Although most of the organizations do not draw clear boundaries among these stages, however, most of the successful businesses follow these stages. The first method is Payback Period method, which is very simple and useful for making short-term decisions. Payback period is the time taken by a project to give back the initial capital cost. The only limitation to this method is that it gives correct returns only if returns are accurate. Secondly, income streams of this method are not related to time, thereby, ignoring time value of money. The second investment appraisal method is accounting rate of return, which is primarily used to highlight the profitability of the investment. This method is considered very useful when different alternative investments are available to company because it makes the investors capable to compare different projects. In this method, the profits are measured against the costs of investments. The disadvantages of this method include its dependence on accounting profits instead of cash flows, ignorance to size and length of investments and ignorance to time value of money. Third investment appraisal method is Net Present Value, which is widely used by businesses. In this method, the changing value of money over the time is taken into consideration. Moreover, this method also allows the investors to compare different interest rates of different investments. Although it is a very simple method however, it is only suitable to compare the projects of same costs and organizations cannot use them to compare dissimilar projects. Cash is the real determinant of profit for a company therefore, various companies use Cash Flow method as investment appraisal method. In this method, the income streams of the project are taken into consideration. A negative income stream is the determinant of loss in the project. Cash flow method also considers the time value of money thereby, determining the yields from investments. Moreover, this method is considered very useful because along with profitability, the risk factor is also evaluated. Although cash flow method compares profitability versus risk however, the true determinant of risk of an investment is the Internal Rate of Return, which is another method of investment appraisal. Internal Rate of Return or discount rate is the rate at which the net present value becomes zero. The benefit of using this method is that business can compare the projects with dissimilar costs under this method. Moreover, calculations of IRR could be made through software. The final method of investment appraisal is profitability index method, which also allows the businesses to compare the projects with different features. As in this method, the index is calculated by taking the ratio of Net Present Value to Initial Capital Cost; therefore, time value of money and profitability both are assessed. Since all of these methods have limitations, therefore, there are different things, which a business should consider before selecting an appraisal method. For example, the degree of accuracy of each method should be determined and ease of using a method has to be considered. Moreover, the factors like extent to which future cash flows, interest rate movements and inflation effects to be predicted should be also considered.5 Therefore, by considering all these factors for making investment decisions and choosing the method carefully, the businesses can reduce their failures in making investment decisions to large extent. Bibliography Bized, 2007. Investment Appraisal. [Online] Available at: http://74.125.153.132/search?q=cache:g4P2XaCqJEAJ:www.bized.co.uk/educators/16-19/business/accounting/presentation/investment1.ppt+investment+appraisal+methods&cd=2&hl=en&ct=clnk&gl=pk. [Accessed 3 February 2010]. Kaplan. S.R & Atkinson, A. A., 1989. Managerial Accounting. [Online] Available at: http://accounting-financial-tax.com/2009/12/capital-budgeting-failure-on-new-technology-project/. [Accessed 3 February 2010]. Mollan, M. S., 2009. Business Failure, Capital Investment and Information: Mining Companies in the Anglo-Egyptian Sudan 1900-13. The Journal of Imperial and Commonwealth History, [Online] 37 (2), 229-248. Available at: http://www.informaworld.com/smpp/content~db=all~content=a912458969. [Accessed 3 February 2010]. The Institute of Chartered Accountants, n.d. Investment Appraisal Techniques. [Online] Available at: http://financial.kaplan.co.uk/Documents/ICAEW/MI_Ch3_p.pdf. [Accessed 3 February 2010]. Read More