The Methods of Capital Project Evaluation - Essay Example

The methods of capital project evaluation vary from payback to the internal rate of return to the net present value. These methods have their advantages in an organization or business, as well as disadvantages. One difficulty that arises from the use of a method such as NPV is the possibility of compounding a risk premium that is in the business. Such compounding ultimately leads to a low NPV. This makes businesses accrue losses rather than reduce the losses (Ross, Westerfield, & Jordan, 2011).
With the use of the IRR, it is frighteningly easy for a business to incorrectly rate some of its exclusive projects. This is where there is the choice of choosing only one project and the inability to do any other. Also, for projects that might start with an initial cash inflow, the IRR method cannot be used in its usual manner (Ross, Westerfield, & Jordan, 2011).
The payback period will not rake in the actual amount of money/capital spent by a firm. This implies that, for such a method, long-term financing is not the objective. The firm will spend more than is required of them if such a method is used by an organization. Inflation often limits this method in many organizations. It can, therefore, lead to irreparable damage to an organization’s finances (Ross, Westerfield, & Jordan, 2011). These are some of the difficulties that arise from the actual application of methods of project evaluation.
In the context of capital budgeting, what does an opportunity cost?
Capital budgeting describes the planning of significant outlays by managers on certain projects in an organization/firm. These projects may have long-term effects. For example, the purchase of new equipment in the firm, or the introduction of new products in the organization may warrant the use of such techniques (Ross, Westerfield, & Jordan, 2011).
In this context, opportunity cost is the value of the most valuable alternative that is often given up if any proposed investment project is to be undertaken. Opportunity costs must be included in capital budgeting. This is because they affect the capital decision-making processes that enable firms to run and rake in profits (Ross, Westerfield, & Jordan, 2011).
Discuss systematic and non-systematic risk.
Unsystematic risk, also known as diversifiable risk, represents risks that are associated with random causes that operate on a firm’s assets. They are eliminated in an organization through diversification. They occur due to factors that are recognizable in the firm like labor, research, development, and marketing strategy among other factors (Vishwanath, 2007).
Systematic factors, also known as non-diversifiable risks, represent risks that affect a firm’s assets due to market factors. These market factors could range from inflation to political events. These risks cannot be eliminated through diversification (Vishwanath, 2007).
Explain what is meant by business risk and financial risk.
These are the primary risks that a business faces daily. However, some differences exist between the two risks. A business risk involves all the risks that occur or arise due to the strategic decisions made by a business manager. This is except the business’s financial decisions. Financial risks are those that depend on how a business organization is structured financially (Ross, Westerfield, & Jordan, 2011). Read More