Financial Management - Essay Example

Financial Management Capital budgeting is a finance technique for the procedure of choosing whether or not to embrace an investment project. There are two standard ideas utilized as a part of capital budgeting: net present value (NPV) and inward rate of return (IRR). (Wharton, 2005: 159) • Should you embrace a particular project? We call this the "yes–no" choice, and we demonstrate how both NPV and IRR answer this inquiry. (Wharton, 2005: 159-160) • Ranking projects: If you have a few option investments, stand out of which you can choose, which would it be a good idea for you to embrace? (Wharton, 2005: 160) • Should you utilize IRR or NPV? Once in a while the IRR and NPV choice criteria give diverse replies to the yes–no and the ranking decisions. We examine why this happens and which model should be utilized for capital budgeting (if theres a conflict.) (Wharton, 2005: 160) Net present value (NPV) is a technique that determines the present value of the inflows and outflows and then simply takes a difference between the two. If that difference is positive it is considered to be returning the required rate of return and is an acceptable project. If the amount is negative it is not providing a sufficient return and would be rejected. In the event two or more mutually exclusive projects all have positive net present values then the project with the highest NPV is selected. The generally accepted advantages of NPV are that it considers the time value of money and is relatively easy to calculate. On the other hand, it is often difficult for laymen to understand the results obtained and (most importantly) it assumes that interim payments received during the life of the project can be invested at the discount rate used in the calculation. This is often not a true statement and can be used to manipulate the results of the analysis. (Lawrence, n.d: 2) Internal rate of return (IRR) is simply a variation of NPV in that it attempts to find the discount rate that provides a NPV of zero. (Lawrence, n.d: 2-3) The internal rate of return (IRR) is a widely used tool for evaluating deterministic cash flow streams, familiar to all students of finance and engineering economics (Brealey and Myers 1996 cited by (Hazen, 2009: 1030)). When used appropriately, it can be a valuable aid in project acceptance and selection. However, the method is subject to well-known difficulties: a cash flow stream can have multiple conflicting internal rates (both above and below the hurdle rate), or no real-valued internal rate at all and can appear to be inconsistent with net present value calculations. As Rothkopf (1965) and others note, it does not extend well to situations involving uncertainty because different realizations of an uncertain cash flow stream can have different numbers of internal rates or no real-valued internal rate at all. This fact makes calculation of the distribution of the internal rate very difficult (although there are approximations). But whether one even needs that distribution is an open question—even under risk neutrality, there is no theoretical guidance as to whether one should use, for example, the mean internal rate versus the internal rate of the mean cash flow.. (Hazen, 2009: 1030) The use of the Internal Rate of Return (IRR) method of capital budgeting is popular as many managers prefer a rate of return method as a decision-making criterion for capital budgeting. However, the Net Present Value (NPV) method is preferred by academics since the rankings of mutually exclusive projects by IRR may not always select the project which will maximize the value of the firm, due to an implied reinvestment rate assumption by IRR. In response to this weakness, the Modified Internal Rate of Return (MIRR) was developed. (Kelleher & MacCormack, 2005: 75)The MIRR is computed in two steps by first compounding the future cash flows of a project to the end of the project at an explicitly assumed reinvestment rate "k" to get a Terminal Value of the Future Cash Flows (TVFCF). For firms which are not subject to capital rationing the reinvestment rate should be the cost of capital which represents the rate of return generally available for projects of equivalent risk (Dudley, 1972, cited by (Cary & Dunn, 1997) ). The essence of the project is then represented in the Initial Outflow (IO) and the Terminal Value. Then the MIRR, the implied rate of return which equates these two values over time, is calculated. (Cary & Dunn, 1997) The payback is simply the amount of time required for an investment to generate sufficient cash flows to recover its initial cost. (Lawrence, n.d: 2) Its advantage is that it is extremely simple to calculate and the resulting number is easily understood. For example, if a project costs $100,000 and it will return cash flows of $50,000 per year, then the company will be paid back in two years. The disadvantages of this method are that it does not consider the time value of money and ignores cash flows (positive and negative) after the payback date. (Lawrence, n.d: 2). However, the payback period has been a widely used capital budgeting tool in the analysis of capital projects. (Boardman et al, 1982: 511) With the above-mentioned definitions in mind, let us consider an example. Let there be two Investments, mutually exclusive which will serve the same purpose. The required return on Capital or the Discount rate is 15%. Let us examine the Cash Flows for the two Projects (Project 1 & Project 2). We will examine the Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period as well as the Modified Internal Rate of Return (MIRR) and make an informed choice regarding which investment opportunity should be accepted and which may be rejected. The table below represents the Cash Flows for a period of 5 years, starting from period Year0 up till Year5. Cash Flows for 2 Investment Opportunities: Year Project 1 Project 2 0 -100000 -100000 1 50000 210000 2 80000 185000 3 120000 145000 4 170000 95000 5 192000 37500 From the above cash flows, we can see that Project 1 has a delayed and increasing cash inflows with the same investment compared to Project 2, which gives almost immediate but decreasing returns. However, merely looking at the cash flows cannot give us an accurate idea regarding which investment is a better alternative. Reqd. rate NPV 1 NPV 2 15% $239,589.29 $339,822.45 20% $188,175.15 $290,223.93 25% $148,149.25 $249,472.00 30% $116,655.12 $215,666.91 40% $71,581.57 $163,522.96 50% $42,205.76 $125,925.93 At the required return of 15% on Capital, Project 1 has a Net Present Value of $239,589.29, compared to $339,822.45 of Project 2. As both projects are generating positive NPV, both may be accepted. However, Project 1 has an Internal Rate of Return of 80% compared to 194% of Project 2, both of which are higher than the Required Return on Capital (15%). Comparing the IRR, Project 2 is a better option. As per the definitions, and literature available on IRR, we can say that the results may be varied in nature; hence, we introduce Modified Internal Rate of Return to check. The MIRR for Project 1 is 52% compared to an IRR of 80% (at 15% discount rate and 20% reinvest rate) whereas, in Project 2, it changes dramatically from an IRR of 194% to a MIRR of 62% (at 15% discount rate and 20% reinvest rate). IRR computations had revealed Project 2 to be a better alternative and MIRR to reveals that Project 2 may be a better option. The Payback Period for Project 1 is somewhere in the 2nd year, where the initial investment is recovered by the positive cash flow, however, the Payback Period for Project 2 is in the 1st year itself, where cash inflows of $210,000 recover the initial investment of $100,000. (SOMEWHERE IN YEAR1) To conclude, we have examined four commonly used capital budgeting tool for making a choice between two mutually exclusive projects. However, we have got varied results. The choice of decision lies with the managers depending on which technique they find most suitable. In this case, personally, I would recommend Project 2, which has a NPV greater than zero, as well as a higher NPV than Project 1. Moreover, its MIRR is marginally higher as well, (62% compared to 52%). The Payback period suggests Project 2 to be more efficient, however, this method does not consider the time value of money, and, the cash inflows or outflows post the payback period are completely ignored. REFERENCES: Boardman et al (1982) THE ROLE OF THE PAYBACK PERIOD IN THE THEORY AND APPLICATION OF DURATION TO CAPITAL BUDGETING, Journal of Business Finance & Accounting, vol. 9, no. 4, Dec., pp. 511-522. Cary & Dunn (1997) ADJUSTMENT OF MODIFIED INTERNAL RATE OF RETURN FOR SCALE AND TIME SPAN DIFFERENCES, Proceedings of the Academy of Accounting and Financial Studies, vol. 2, no. 2. Hazen, G. (2009) An Extension of the Internal Rate of Return to Stochastic Cash Flows, MANAGEMENT SCIENCE, vol. 55, no. 6, June, pp. 1030-1034. Kelleher & MacCormack (2005) Internal Rate of Return: A Cautionary tale, The McKinsey Quartley. Lawrence, H. (n.d) The Use of Modern Capital Budgeting Techniques., N.A. Wharton (2005) INTRODUCTION TO CAPITAL BUDGETING, Wharton Business School. APPENDIX: Read More