Terms in Strategic Planning and Capital Budgeting - Essay Example

Terms in Strategic Planning and Capital Budgeting Net present value Net present value or NPV is defined as present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project.(Accounting explained)Strengths. Analysts consider NPV as one of the most dependable procedures to be used in capital budgeting since it uses the time value of money thru discounted cash flows. Time value of money is the idea that the money available today is worth more than money received in the future because of its earning potentials.

(Investopedia) Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project. Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow.This formula is best used in analyzing the profitability of a project. NPV provides a value that when it turns positive project should be accepted, or rejected when value is negative. A negative NPV produces a negative cash flows. NPV is also an ideal calculation when deciding on two projects, or comparing between them gives alternativesWEAKNESS NPV is based on future cash estimates of the project that could be different from actual results and the difficulty of computing when the cash flows are uneven yearly.

Another problem related to NPV is the use of discounting and selection of rate because different rates provide different values.2. Payback PeriodPayback period is an accounting tool that is used to measure the time it will take to recover the original investment. The decision rule here is to accept the project if the payback period is less than projected.(Accounting Explained)Strength of the measure. This formula is easy to calculate and is one of the simplest tools of measuring profitability.

It is also a good measure in ranking projects that would return money easily. For instance, the payback period of a project requiring $100 million dollar and is expected to generate a $5 million return for 5 years:Payback is: Initial investment / Annual cash flow = 100/ 25 million = 4 yearsWeakness.Since expected cash flows are estimates, it is possible that there is a certainty that what is projected will not be the probable result. It could also suggest that there would be uneven distribution of expected cash flow.

This is due perhaps that changes in business is continuous and substantial. We should remember that in business, the product, the consumer, the competition, and the workforce today are very much different from ten years ago, and we cannot predict outcome of the economy. In addition, this model does not take into account cash flows that occur after payback period is reached. 3. Internal Rate of ReturnInternal rate of return is the discount rate used that equates the present value of future investments with the initial investment.

The decision rule here is to accept the project if the IRR is not less than the targeted IRR. This is best illustrated by the question: “What rate of return would give the stream of future net cash benefits a combined preset value equal to the present investment required to purchase the stream?” IRR is often referred to as cost of capital. All cash flows are first discounted at some rate, like, 10 percent. If the NPV is positive, it is again discounted again at a higher rate, like 15 percent.

If the NPV at this rate is negative, the true rate of return must be between the two rates.(Accounting Explained)Weaknesses: Choosing the discount rate is a case of trial and error, and choosing an investment rate is a condition for investment because of investor’s aversion to risk. The greater the risk, the less the stockholder will be willing to pay for a dollar of anticipated earning. Strengths. This method is best used when deciding between two wherein the projects with the highest IRR should be accepted as a rule (Accounting Explained). 4. Accounting Rate of returnAccounting rate of return is an appraisal technique and is defined as the ratio of the estimated accounting profit of a project to its average investment.

It is calculated as:ARR = Average Accounting profit / Initial investment, where:As described, Average Accounting profit is calculated as the arithmetic mean of accounting income expected to be earned during each year of the projects life time.(Accounting Explained). Initial investment is sometimes replaced by average investment due to the reason that the book value of the project usually declines over its life time. Average investment is calculated as the sum of the beginning and ending book value of the project divided by 2.

StrengthsThis method is easy to calculate and considers the value of profitability of investment.Weaknesses.This method does not consider the time value of money. ARR uses accounting income instead of cash flow information, and it is not suitable measure for projects having high maintenance cost because its viability depends on timely cash inflows. For instance, Accounting income is recorded as revenue at the time it is earned and not when it is received. It immediately increases the net income even when actual cash is not yet on hand.

This is common when sales are done on terms, i.e. 30 days. Sales revenue immediately increases, but there is no cash flow until payment arrives. This means company has no money until payment comes. (Carol Wiley, 2013)5. Profitability Index. This is another measure to rank project proposals. It is calculated by dividing the present value of future cash flows to be generated by the initial investment with the initial investment, or capital. The decision rule is: if the answer is less than 1.

00, proposal is rejected; but if the profitability index is greater than l.00, proposal will make a profit. A profitability index of 1.5 means owner can expect a return of $l.50 for every $1 invested. (Peavler, R., 2013)Strengths. Profitability index are preferred by investors in ranking proposals because its ranking is based on per dollar return.WeaknessDifficulty in using the kind of ranking, according to Peavler, R. (2013) is that it does not take into consideration the size of the projects when evaluating.6. Break Even Analysis is an economic study that describes a certain point in business operations wherein costs (expenses) and revenues (sales) are equal, so the company just makes even.

Anything above break even point is profit, and below means loss. BEV takes into consideration the fixed costs and variable costs in producing item. Graphically, it is demonstrated asSource: SBA.Gov.The above BEV CHART shows the relationship of costs, volume and profit. It is a diagram that shows the amount of profit to be expected at various sales volume under different specified working conditions. At price $20, quantity to be sold is 3, which is the BEV. There are three things measured here, break even unit, price and costs.

Profit starts when more units of the products are soldBEV helps managers find the lowest quantity of sales that that will include its fixed and variable costs. It helps managers in setting prices when making a bid, and find if its price can stand competition. Managers can also decide where to adjust on costs of variable expenses when needed, like adjusting its manufacturing costs, or advertising budget, personnel and selling expenses.7. Limiting Factors are constraints that limit level of production.

These could be level of demand, shortage of skilled labor, lack of capital, machinery, and others. Due to these constraints management cannot produce as many products as it wishes so. In order to maximize production in relation to the constraints, management has to introduce a ranking or a product mix. This is of practical use when company decides on multiple product production, and will do it by ranking. Highest ranking goes to the product that gives greater production using available resources.

Then, the remaining resources will be allotted to the next ranking products until every resources are consumed. (College Accounting Coach)ReferencesAccounting Explained.(2011) Net Present Value http://accountingexplained.com/managerial/capital-budgeting/npv---- Payback Period. http://accountingexplained.com/managerial/capital-budgeting/payback-period--- Internal Rate of Return http://accountingexplained.com/managerial/capital-budgeting/irr--- Accounting Rate of Return http://accountingexplained.

com/managerial/capital-budgeting/arrInvestopedia. Time Value of Money w.investopedia.com/terms/t/timevalueofmoney.asp#axzz2Nf70zPgwCollege Accounting Coach. (2006) Short Term Decision Making.- Limiting Factor. http://basiccollegeaccounting.com/2006/08/short-term-decision-making-limiting-factor-part-1/#containerPeavler, Rosemary. The Profitability Index. Business Finance. About.com. http://bizfinance.about.com/od/Capital-Budgeting/qt/overview-profitability-index.htmSBA. Gov. Break-Even Analysis.

Retrieved from < http://www.sba.gov/content/breakeven-analysis-know-when-you-can-expect-profit.Wiley, Carol (2013) Difference between Income and Cash Flows. Small Business. Chron,com. Retrieved from http://smallbusiness.chron.com/difference-between-income-cash-flows-22901.html