Drawbacks of Net Present Value as Capital Budgeting Technique - Assignment Example

?Question Primary Drawbacks of Net Present Value as Capital Budgeting Technique: This method or tool is used to assess the profitability of an investment opportunity. This tool is classified as one of the capital budgeting technique that is used by a firm to assess the viability of a project. The application of this tool is dependent upon the future cash flows that the investment opportunity or project will generate. This technique takes future cash flows generated by an investment opportunity and discount them to reach the present value of those cash flows. This entire process has multiple loopholes, for instance the uncertainty that is prevailing when it comes to estimating future cash flows of that investment opportunity is high enough to put this technique under scrutiny. Next loophole is regarding the discount rate that is used to reach the present value of a cash flow. Again the accuracy of discount rate used is of critical importance in determining the correct value of the cash flow’s present value. This makes NPV value dependent or sensitive to the value of discount rate and forecasted cash flows. Third loophole that is pretty much evident from the assessment of this tool is that this tool takes into account information that is present at the time of decision making, thus it does not take into account changes in the initial conditions of an investment opportunity. The fourth loophole that can be seen is that this tool is only applicable when projects being assessed are tangible and quantifiable. And in reality firms undertake certain projects that are aimed at enhancing the brand equity, such projects are out of the scope of NPV (Kent & English, 2011). Question # 2: Comparison of Net Present Value and Internal Rate of Return: This tool or technique is another capital budgeting technique. IRR is the discount rate that turns the net present value of forecasted cash flows from an investment opportunity equal to zero. For an investment opportunity to be selected by a firm, it needs to have an IRR that is higher than the required rate of return. The general rule with IRR is that: higher the IRR as compared to the cost of capital, higher will be the net cash flows to the investor. The fundamental advantage of this method is that it allows an investor to assess the returns generated by the original investment (Helfert, 2004). A decision regarding a particular investment opportunity that is based on NPV technique will find itself under scrutiny when assessed using IRR technique. While this fact is not true for independent projects where both techniques will yield similar results, but when it comes to mutually exclusive projects (one project or the other) these tools do not yield a consistent result. The reason behind this conflict is that the set of investment opportunity that is being assessed consists of projects that vary in their size and timings of their future cash flows (Helfert, 2004). So it is clear that if a company is deciding between two investment opportunities, it will encounter a problem when it is using NPV and IRR to assess the value of these investment opportunities for the company. In this conflicting situation the company shall have to decide whether it will make its decision based on NPP or IRR (Helfert, 2004). Question # 3: Avenues to raise equity for a Profit Driven Firm: A profit driven firm, if assumed to be a corporation, has multiple options at its disposal to raise new equity capital. The first option that it has is to go to its existing shareholder for additional capital. The second option it has is to add more shareholders into the company by offering new share in the primary market. The third option available to a profit driven firm is that it can seek help from a venture capitalist firm; again this will be in exchange for some portion of the company’s equity. The fourth option available to the company is that it asks a bank for a loan in return for interest payments. These mentioned options are most suited to meet the company’s short-term capital requirement need. However, companies do need capital that can be invested on long term projects, for this a company needs capital from a source that allows them this luxury. In such circumstances, the company can visit the bond market. The company can issue its own bond to raise capital for a long term project (Gitman, 2003). Avenues to raise equity for a Non-Profit Driven Firm: For such companies the sources of new equity are limited because they are not engaged in any kind of revenue generating activity. The most these companies can do is to initiate a fund raising campaign, engage in lobbying activity, bring new and influential members on board and last but not the least seek the help of corporations who believe in corporate social responsibility (Gitman, 2003). Question # 4: Advantages And Disadvantages To A Taxpaying Entity In Issuing Debt As Opposed To Equity: This decision to use equity capital as opposed to debt capital is dependent upon the stage of the economic cycle. A company needs to have a firm understanding about the operating requirements of each of these stages. These stages come as a paradigm shifter for the companies and it is imperative upon these companies to adjust their mode of operations according to the requirements of these stages (Khan, 1993). In the period of recession, the use of debt capital can be very expensive for the company. Since demand in this period is low and inflation is high, this means that interest payment on debt will be higher and costlier to the company. In this stage, the use of equity capital will be better for the companies, since it would be cheaper than debt capital. It is this dynamic that creates a situation in which companies having sufficient equity capital can buy distressed companies during the period of recession (Khan, 1993). However, when the economy is experiencing the boom stage or recovery phase, it is better that the company raises capital by means of a debt issue, and conserve its equity capital. In this stage, debt capital is cheap as compared to equity capital, since demand in this stage his high and inflation is low. The company’s products will be in higher demand which will enable it to generate revenues, and thereby paying off its debt easily (Khan, 1993). So it can be concluded that the decision to use equity or debt capital depends upon the stage of the economic cycle that is being experienced by the company. Question # 5: Methods for Healthcare Provider to Strengthen its Credit Rating: In order for a healthcare service provider to improve its credit rating, it needs to satisfy the operating protocols set by U.S Public Health Service Commissioned Corp and U.S Department of Health and Human Services. These credit rating determining protocols place a huge emphasis on the facilities provided by the healthcare service center and the number of researches conducted by this center (McLaney, 2009). When talking about the facilities, the most important thing that the service provider needs to do is develop a pool of qualified physicians. Next it needs to have sufficient number of support staff comprising of nurses, ward boys and junior doctor. Thirdly, these service centers should be offering services to patients 24/7. Last by not the least, these service centers should have effective systems in place to support recording keeping activity, drug administration, and employee behavior and etch. The second part of the credit rating has to do with the number of researches conducted by a service center and the implications of these researches on the society. This aspect of credit rating is similar to the aspect of ranking used in rating universities. The reason why this aspect is so important is that these researches conducted by these centers provide valuable insight regarding upcoming diseases and outbreaks. These centers after compiling their findings supply valuable data to the U.S Health Department, so that the department could develop provisions for unprecedented circumstances. This helps to ensure that the country is ready to face any kind of disease outbreak. Question # 6: Acts On Behalf Of Bondholders To Ensure That The Issuing Facility Not Only Is Complying With The Covenants Of The Bond But Also Is Making Timely Principal And Interest Payments To The Bondholders: The exchange on which the company’s bond is listed makes sure that the transactions that should happen between a bond holder and bond lender take place. This body ensures the no party violate the terms of the agreement. In case the bond lending company defaults on in its interest payments or principle payment, the stock exchange has the power to declare the company as black listed or even cancel its membership. The actions taken by the stock exchange can have drastic negative ramifications for the company. On such ramification would be that the company would not be able to seek new capital from the bond market. Most importantly, the damage these actions would cause to the reputation of the company; these damages would be beyond repairing (Lee, Lee, & Lee, 2009). Another external authority that closely watches the practices and dealings of a company are credit rating agencies like S&P, Bear Stern and etch. The input given by them regarding a company carries a lot of weight when it comes to influencing the opinion of the investors regarding the company (Lee, Lee, & Lee, 2009). Last but not the least the government of the country can play a crucial role in such situation; it can profess its existence through the country’s Securities and Exchange Commission. These three authorities work in unison to regulate the behavior of companies operating in different financial markets of the country. References Gitman, L. (2003). Principles of Managerial Finance. Boston: Addison-Wesley Publishing. Helfert, E. (2004). Techniques of Financial Analysis: A practical guide to managing and measuring business performance. New Delhi: Tata McGraw-Hill. Kent, B., & English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects. Hoboken: John Wiley & Sons. Khan, M. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill Higher Education. Lee, A., Lee, J, & Lee, C. (2009). Financial Analysis, Planning, and Forecasting: theory and application. Singapore: World Scientific Publishing Co. Pte. Ltd. McLaney, E. (2009). Business Finance: Theory and Practice. New Jersey: Pearson Education. Read More