Capital Budgeting Measures - Research Paper Example

? PROS AND CONS OF CAPITAL BUDGETING MEASURES Executive Summary Organizations have to do investment appraisal before undertaking long-term projects in order to determine the feasibility and profitability of their investments. Capital budgeting techniques are applied in the determination of these projects. There are two major types of capital budgeting techniques. The first types are the non-discounted methods where there is no determination of the present values of the future expected cash flows. Examples here include the payback period and the accounting rate of return. The other techniques employed in the evaluation of projects are the discounted methods of appraising capital projects. In these methods, the future expected cash flows are discounted at the organizations cost of capital to determine the projects’ to be undertaken. In this approach, only projects with positive net present value will be undertaken in order of their profitability. The idea of capital budgeting before investments are undertaken is necessitated by the need to avoid incurring losses and to maximize the returns of a firm at the lowest cost possible. The budgeting process is also necessary because of the capital constraints that companies face. Due to capital inadequacy, companies and firms will not be in a position to undertake all the projects and therefore creating the need to only undertakes the most profitable investments (Baker, 2011). Failure to undertake capital budgeting process may cause organizations to realize heavy losses and have going concern problems. In this paper, discussion has made on the pros and cons of the methods of NPV, IRR, MIRR and discounted payback method. I would prefer the use of NPV and IRR methods of capital budgeting in instances that we have independent projects with equal sizes. The two methods can thus be used interchangeably and would be preferred because they incorporate the risk and time values in their calculations. MIRR, which is an improvement of IRR, is also preferable in cases where we have projects having irregular cash flows and therefore provides a solution to some of the short falls of IRR. Investment appraisal should therefore be keenly undertaken by qualifies personnel and all necessary weights should be integrated when determining the best method to use. It must be noted that all the methods used in capital budgeting measures have some limitations (Brigham & Ehrhardt, 2010). The best that should be done is to ensure that such deficiency does not impair materially the decision to be made. Net Present Value The NPV of a project is the present value of all the future expected cash inflows less the present value of the future expected cash outflows (Parrino & Kidwell, 2009). In this case, the future expected cash flows are determined currently and discounted using the cost of capital of the firm. NPV takes into account only cash flows and does not use the accounting profits or items like depreciation. It is commonly used by many organizations in their investment appraisal method. Most businesses and organizations that are interested in the viability and profitability of projects have normally applied the NPV method as a way of evaluating their actions. The wide acceptance of NPV is because it is easier to understand and to interpret the results even to those without financial knowledge. NPV has various advantages. To begin with, the method considers the time value of money and therefore shoulders the effect of inflation and interest rates that are likely to adverse affect the value of money. It must be noticed that the value of 1 dollar today may not be the same as the value of the same dollar in 3 years time because of time difference. The second reason for use of this method is that it gives the criteria to use in the selection of the projects to be undertaken. The firms may undertake investments with positive NPV’s because they have a net gain as opposed to those with negative NPV’s which results into losses. The investors or firms are therefore definite of the criteria of selection (Shim & Siegel, 2009). In addition, NPV approach considers all the future cash flows as opposed to some methods like the payback period where not all cash flows are used in project evaluation (Brigham & Ehrhardt, 2010). The method thus maximizes the objective of the firm that is to maximize the value of the shareholders by creation of wealth. The NPV approach also suffers some drawbacks. The first problem relates with the estimation of future expected cash flows. The accuracy or reliability of the values may not be easily determined and is therefore not appropriate to rely upon. The use of the weighted average cost of capital as the discounting rate depends on the assumption that the capital structure of a firm does not change and that the cost of each specific source of financing remains constant (Turnbull, 2010). This is not normally true for most financing decision. Finally, the method fails to take into account the size of the project. Projects are therefore compared irrespective of the size or resources required in undertaking the investment. Internal Rate of Return The second capital budgeting technique is the internal rate of return (IRR). This method determines the rate of return that the investor will earn from the capital invested. Internal rate of return is that rate of return that makers the NPV of a project to be zero i.e. all projects whose rates of return exceed the cost of capital should be expected (Brigham & Ehrhardt, 2010). Investments that have a higher rate than the IRR rate are said to be profitable and hence increases the shareholders wealth maximization. This method has been favored because it takes into account the time value of money and considers all the future cash flows. The method determines the rate of return that the investors expect and will accept projects whose rate of return are above those of the investors set limit (Parrino & Kidwell, 2009). For Mutually exclusive projects in order of their rates of return and those with the highest rates of return will be prioritized. In IRR, it is assumed that the cash flows that arise before the end of the projects life are reinvested at the cost of capital. IRR is also acceptable because the risk and time horizon are all integrated in the evaluation of the projects However, IRR suffers various limitations that make it challenging to use. First, the method can give conflicting rates of IRR in instances that the cash flows are irregular or non-normal (Parrino & Kidwell, 2009). Projects that require capital investments in the other years will give conflicting result. The second cons of the method are that it is tedious to calculate especially when the trial and error method is used in the determination of the IRR. Further, IRR is also pegged on the future expected cash flows that is not certain and is subjective (Baker, 2011). Moreover, it cannot be used for projects with positive cash inflows at the beginning of the project and in mutually exclusive projects. Modified Internal Rate of Return Modified internal rate of return (MIRR) was developed to check into the drawback of IRR. The method is used to evaluate alternative investment of equal size. The method solves two problems that arise from the use of IRR. The first drawback that the method solves is that of irregular cash flows which leads to conflicting rates (Brigham & Ehrhardt, 2010). MIRR also solves the drawback that the funds generated from the projects are reinvested at the same rate of return. In this method, the reinvestments are taken at their actual rates of return. MIRR is has several pros similar to those of NPV and IRR. To begin with, the method considers all the cash flows expected from the projects and takes into consideration of the time value of money (Turnbull, 2010). It therefore considers the inflationary effects together with the variations in the interest rates. MIRR is also favored because it offers the acceptance criteria and can rank projects of equal sizes. On the other hand, MIRR has some cons. For first, MIRR is complex to calculate and is difficult to understand by some financial managers who lack specialized knowledge of finance. The method also suffers the drawback that it cannot rank projects with different sizes (Shim & Siegel, 2009). It must however be noticed that MIRR produces better results than the IRR in instances that there are cash flows which are irregular and positive cash flows in the initial start of a project. The management should therefore embrace better methods that will lead to best performance if their stakeholders’ interests have to be satisfied. Profitability Index Profitability index is also a method that can be used in making investment decisions of a firm. PI first determines the present value of the project that is then divided by the initial capital investment (Brigham & Ehrhardt, 2010). In this method, only investments with a PI greater than 1 should be accepted while those with PI of less than one should be rejected because they are not in line with shareholders wealth maximization. PI has pros similar to those of NPV like considering all the future cash flows and considering the time value of money. Risk is also considered using cost of capital i.e. future cash flows are taken to be more risky than those of the near periods are (Baker, 2011). The method also provides criteria for accepting or rejecting investments therefore investors are not on what procedure to follow in ranking projects (Turnbull, 2010). Projects with higher PI should be first considered. However, PI suffers drawbacks like not considering the size of the project and cannot be preferred for mutually exclusive projects. The calculation of PI also entails the determination of cost of capital that may be subjective. Others include the problems in the determination of future expected cash flows, only used for divisible projects and difficulty to compare projects with different periods. Discounted Payback Period The final capital budgeting method that will be considered here is the discounted pay back method of investment appraisal. This method modifies the normal pay back method by incorporating the time value of money in its calculation (Baker, 2011). Here, the period taken to recoup the initial capital invested is determined after discounting the future expected cash flows. Projects are compared according to the time required to regain the capital invested and those projects with shorter payback periods are prioritized. The first advantage of this method is that it considers the time value of money and therefore looks into the riskiness of cash flows relating to the future periods. The method is also good because it prefers projects with shorter payback period hence giving definite criteria for accepting or rejecting a project (Brigham & Ehrhardt, 2010). The drawback of this method is that it fails to incorporate the all the cash flows hence likely to give misleading results. It only considers the period up to when the initial investment is recoup and ignores the cash flows thereafter (Shim & Siegel, 2009). The method as well fails to consider the sizes of projects in determination or ranking of the projects. Since it considers only the time duration required to get back the capital invested, it fails to determine the absolute value of the profit the firm will earn. In real practice, capital budgeting measures has been responsible for the slow level of development in many African countries. The failure to undertake, appraisal in realistic manner and the lack of doing a feasibility study has resulted negatively on the rate of economic growth. Profit making business have to conduct their research on the projects that are able to maximize the wealth of shareholders. They conduct thorough feasibility and financial analysis before investing in such projects. How a business performance and how the assumptions are made really matter for the business general performance and competitiveness (Baker, 2011). The rationale of capital budgeting is also pegged on the huge amount of resources that are required to undertake some projects. When incurring heavy expenditures on the acquisition of machinery or investing in a particular product line, the investment appraisal techniques will assist in preventing irreversible losses that may result. The financial managers of each organization that is geared towards increasing their returns or for nonprofit organizations who are interested in getting value for their many will always appraise their projects carefully and continuously (Parrino & Kidwell, 2009). Currently, even the governments have started appraising their projects to ensure that their development agenda is achieved. The failure by African governments to closely scrutinize their expenditures on the provision of public goods was the reason for the failure of most African and other developing economies (Shim & Siegel, 2009). With accountability demand by the donors, government agencies have started undertaking measures that are aimed at ranking their projects in order to invest in the most profitable ways amidst the capital constraints. In conclusion, capital budgeting measures are essential for the determination of the projects to be undertaken by any organization. Failure to take these measures will automatically result in the failure to get the returns desired and maximize the welfare of the stakeholders. The investment appraisal methods should be analyzed and the methods preferred should have the following characteristics: maximize shareholders worth, have a selection criterion, and take into consideration the time value of money. NPV, IRR, and sometimes MIRR are mostly used because they possess such characteristics. Appendix Abbreviation IRR- Internal Rate of Return MIRR- Modified Internal Rate of Return NPV- Net Present Value PI- Profitability Index Key Terms Capital Budgeting Discounting Investment Appraisal Payback periods Time value of money Wealth maximization Reference List Baker, H. K. (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. New Jersey: John Wiley and Sons. Brigham, E. F., & Ehrhardt, M. (2010). Financial Management Theory and Practice. Mason: Cengage Learning. Parrino, R., & Kidwell, D. (2009). Fundamentals of Corporater Finance. New Jersey: John Wiley and Sons. Shim, J. K., & Siegel, J. G. (2009). Modern Cost Management and Analysis. New York: Barron's Educational Series. Turnbull, A. (2010). Capital Budgeting. Pitchcare . Retrieved from http://www.pitchcare.com/magazine/capital-budgeting.html Read More