Capital Budgeting Evaluation Techniques - Example

Capital evaluation techniques [Insert affiliation] Introduction   Oman Refineries and Petrochemical Company is one of the companies that operate in Oman country. Oman Refinery Company merged with Sohar Refinery Company in 2007 to form Oman Refineries and Petrochemical Company. Due to its demand in the expansion, profit generation and maximization of shareholders wealth, the company had undertaken a capital investment in two mutually exclusive projects which are oil and gas. From the available data from the annual report, it is clear that the company generating cash flows from the capital investments in the year before. Due to viability of the company’s capital investment, a year later the investments increased cash flows. It should be noted that various techniques favor different firms because of the difference in the business undertakings. This, however, calls for analytical evaluation of the capital budgeting methods in the view of their merits to firms’ investments. The most common capital budgeting methods that are employed include the net present value (NPV), the payback period (PB), the average rate of return (ARR), the profitability index (PI) and finally the internal rate of return (IRR). The NPVcapital budgeting technique It is one of the most common capital budgeting techniques that are used by various financial analysts. The method measures the value of money at the moment that is when the time is zero. Given that there are some cash flows to be received by the firm at a future date; such cash flows are discounted at a certain discounting rate to get their respective present value. The axiom in using this technique is that the non-cash items such as depreciation should reasonably be adjusted. The NPV value of such an investment is, therefore, calculated by getting the aggregate; present values then subtract the initial capital outlay of the investment. NPV = {} – B0where B0 is the initial capital outlay Z1, Z2, Z3 are cash flows and k is discounting rate. Decision criteria that are used to determine whether to accept or decline Given that the net present value of the mutually exclusive investments is more than zero (NPV>0), the investment with the highest net present value should be undertaken. When the net present value of investments are zero (NPV = 0), the financial manager becomes indifferent and, therefore, is required to take into consideration other factors such as the long-term effects on the environment and the capital available to fund such investments (Buckley, 2006). The PB capital budgeting technique It is the non-discounting procedure that considers the time those investments will take to return the investments capital outlays. The investment that takes a shorter period to recover the initial capital cost is better than the one that takes a longer period. This method takes into account the cash flows and not the accounting profits that are generated by the investment/ project. The decision criteria for the PB technique An investment that has the shortest payback period should be given the priority otherwise, that which takes a longer time to recover the original capital outlay should be declined. Advantages of using PB as a method of capital budgeting It is one of the simplest capital budgeting techniques as far as computing is concerned, and therefore, majority of the financial managers use it. The technique is the most applicable in circumstances where there are high risks investments are available, and there is a dilemma on which investment should be chosen (Riahi-Belkaoui, 2009). Nevertheless, the technique is the most efficient and cost-effective investment appraisal procedure as it does not necessitate the employment of complicated devices like computer and profound analysis. The method emphasizes on the liquidity of the company hence re-investment of finances that are realized in advance. Disadvantages of PB as a budgeting technique The method suffers a setback of not considering all the cash flows that are generated during the economic life of the investment. Also, the method does not ascertain the productivity of an investment but rather looks at the time such an investment will have to take to pay back the capital outlay. Such technique can cause the financial manager to make unsound decision as far as investment decisions are concerned. The IRR This capital budgeting technique strives to equalize the present value of expected benefits to initial capital that is financing the venture (Grant, 2008). The IRR can, therefore, be described as a discounting rate that equates the net present value to zero. C0= The decision criteria that are used in IRR When the earnings from mutually exclusive investments are more than the cost of finances, the investment with the highest IRR should be undertaken. Conversely, if the costs of funds are more than the earning, the investments should be declined. However, under circumstances where the IRRs are equal to the costs of capital, the financial manager should take into account other factors that may affect the projects/investments. The ARR capital budgeting technique This method considers accounting profits and not the cash flows. ARR = The decision criteria that are used in average accounting rate of return capital budgeting technique. In the evaluation of mutually exclusive investments, the investment with the maximum ARR should be accepted and be undertaken (Droms, 2013). When the investments are mutually exclusive, it is necessary that they should be ranked from the one with the highest ARR to the one with the lowest ARR then pick that which has the highest ARR rate. Advantages of ARR It is simple to understand and interpreted. The accounting information that is used is readily available from the financial statements of companies. Disadvantages of the ARR as budgeting technique The method is not concerned with the time value of money which is imperative in the assessment of projects. It makes use of accounting profits that can haphazardly be determined hence their accuracy is dubious. Companies with high rates of return on their assets can reject profitable investments as they tend to set minimum acceptable ARR while fewer profitable firms can set level acceptable ARR and end up accepting bad projects. The technique disregards the ostensible fact that proceeds are often re-invested. The PI capital budgeting technique It is a method that computes the proportion of cash flows’ present values at a certain rate of return on the initial payment discharge on an investment. It determines the return of an investment (Levy &Sarnat, 2007). PI = The decision criteria that are used in PI capital budgeting technique An investment should only be undertaken if it has a profitability index which is greater than one. When the profitability index is equal to zero, the financial manager becomes indifferent and should, therefore, consider other factors. The investment is declined when the profitability index is less than zero. Advantages of PI as a capital budgeting technique The method accounts for the time value of money. The method orders the investments according to the economic prestige giving financial managers distinctive decision evaluation criteria. It can be used in making assessments of investments with different sizes. Disadvantages of PI as a capital budgeting technique The method infringes the shareholders wealth expansion and makes an assumption of the discount rate being certainly known and constant which is not the case in reality. Effect of long-term investments on liquidity and profitability of the firm Long-term investments require huge capital for investment. Such investments extend their returns for a period more than a year. Oman Refineries and Petrochemical Company recorded sales of 369.7million which was an increase of about 16.1 percent from the previous year (318.5 million). The net profit as per 2014 was 10.7 million. This was an increase of approximately 3.1 per cent. From this data, we can compute return of investment using = 27.26%. The return on investment shows the profit return on investment of total assets. So such investment decreases the profitability of firm hence reduction in shareholders’ wealth maximization (Mock, 2007). Additionally, the ability of an organization to meet its liabilities when they fall due is reduced as the investment capital cannot be converted to cash easily. Analysis of capital budgeting techniques used by Oman Refineries and Petrochemical Company Oman Refineries and Petrochemical Company had $50 million as the capital budget to finance its crude oil refinery machine project. The cash flows that were generated from the project were 12 million, 17 million, 14million, 19 million, and 21 million in the year 2009, 2010, 2011, 2012 and 2013 respectively. Considering the inflation rate and market risks, the discounting rate of return stood 15%. The machine had a useful life of 5 years and the depreciation was on a straight line basis. The corporate tax was. The net present value was computed as below Year Cash flows Discounting rate 15% Present value cash flow 0 50 million (1.15) -0 (50 m) 1 12 million (1.15) -1 10.43 m 2 17 million (1.15) -2 12.85 m 3 14 million (1.15) -3 9.21 m 4 19 million (1.15) -4 10.86 m 5 21 million (1.15) -5 10.44 m The total present value ∑ 53.79 The net present value =capital outlay – the cash flow present value. (53.79 -50) m = 3.79m. The project was undertaken since it had a positive net present value. The ARR was used as it takes into consideration the profitability impact of investment (Peterson, &Fabozzi, 2006). The ARR was computed as follows: depreciation 1 million per year. Year 1 2 3 4 5 Earnings before Dep 12 m 17 m 14 m 19 m 21 m Less: Dep 1m 1m 1m 1m 1m Earnings after Dep 11 m 16 m 13 m 18 m 20 m Tax @ 30% 3.3 m 4.8 m 3.9 m 5.4 m 6 m Profit after tax 7.7 m 11.2 m 9.1 m 12.6 14 m Average income = = 10.92 m Average investment (50 m + 0)/2 = 25m ARR = (10.92/25)*100 = 43.68% The PI = = (53.79/50) =1.08. The project was viable as it is more than 1 otherwise it could have been decline. Effect of inflation, depreciation and taxation on capital budgeting The inflation is one of risks that can occur on investments hence making the investment less viable. Inflation leads to an increase in discounting rates which has a direct effect to the cash flows. Increase in discount rate leads to a decrease in the present value cash flow making the investment less promising. This will, therefore, call for adjustment (increase) of both the cash flow and discount rate of the Refineries Company to match. Depreciation is the cost that is associated to wearing and tearing of an investment. It is normally added back in calculation of cash flows s it is a non-expense and therefore has no effect to cash flows. However, depreciation has an indirect effect of reducing the cash flows and consequently to the capital budgeting of the company. Taxation is a statutory amount of money that is levied by the state. Normally, the corporate tax is 30% but any increase in the tax above this level will adversely affect the government hence calling for more funds to expand the budget to cover the cost that the company will incur. Therefore, increase in the tax will lower the income generation from the project making the capital budget ineffective. Capital rationing It is a verdict by the financial managers to which of the investments that meet critical requirements are to be invested. This is done when the firm has only a limited fixed number of funds and has to allocate among several competing capital expenditures. Such decision occurs at any point in time when there is a budget constraint on the availability of money that can be invested in a given period. In such a scenario, the firm is forced to depend on funds that are generated internally because it is hard to borrow (Goddard & Marcum, 2012). Here, the company tries to make a selection of combination of investments that are anticipated to generate high firm’s value given the constraining limit. Finally, the capital rationing does not permit maximization of the utmost value generation as all profitable investments are not usually accepted hence not maximizing the NPV. Limitations of capital rationing The capital rationing by Oman Refineries and petrochemical company led to the financing of few projects which had high net present values leading to sub-optimal maximization of the value. Additionally, capital rationing to misleading in selection of small projects and leave out larger projects because of inadequate capital that the company has. (Panorama, 2015). When the company used capital rationing, it did not add any intermediate cash flow from the investment when calculating the project’s viability hence not considering the time and value of money. This led to poor investment decision being made. The capital rationing led to the company to undertake some other portions of the viable projects instead of undertaking the whole projects. Post audit It is an independent review on how an investment process was conducted. Oman Refineries and Petrochemical Company has been set up an independent body to carry out an audit for the various projects that are to be financed. The post audit, see to it that resources are devoted to beneficial projects, the resources are used economically and for the purposes which are authorized only. The post audit was carried by the internal audit committee after an interval of three months. The committee disclosed vital information that the capital should be scaled up by 15 percent due to the effect of inflation in the economy. This led to the generation of zero-based capital budgeting where every capital outlay of the investment was stated afresh. This helped the Oman Refineries company to make a sound decision based on the post audit information that was revealed later. The roles of post-audit are: To improve forecasts: post audit can improve forecasts especially when people become conscientious and realize that their hard work will be compared to the actual outcome. Vices such as biases are seen and get rid of with an immediate effect. New techniques are explored, tested and integrated appropriately after such actions are examined. To improve operations: given that a particular division has made the prediction and undertaken a project, their status profile is at risk. When the cost is above projection and the sales being below the projection, such division will put in efforts to align the results with the forecasts. To discover troubles and suitable solutions so that remedial action may be in use: when the audit is performed at the outcome audit period, it is possible to amend the ongoing project and to other investment projects. Where serious mistakes have been committed, it makes it possible to decline the investment to curb future losses. To acknowledge the lessons that can be acquired for future decisions: though such lessons may not guarantee the improvement of planning and implementation of prospect investments, it may be of vital importance in strategic planning procedure. To put forth discipline in the investment planning and managing process: when the managers become aware of post audit undertakings, they become cautious in developing axioms and rough estimates and also become keen in making investment decisions. They too become careful when they manage investments to their conclusion. Recommendation The best capital budgeting technique is NPV. This is because the method takes consideration of the time value of money; it is in line with the shareholders wealth maximization, considers the profitability of the investment that payback period and considers all cash flows of the investment. Finally, it is the most accurate capital budgeting technique hence permitting sound investment decisions. Conclusion In a nutshell, capital budgeting techniques that are align with shareholders wealth maximization, that consider the value of money and time and the techniques that accounts for all the cash flows should be used as capital budgeting methods . Such methods include the NPV, the ARR, and PI. Post audit is important to organizations as it proposes constructive basis of control. This by investigating each phase of investment procedure using data sourced from diverse sources hence making it possible to identify what might have gone astray with the plan. Therefore, post audit should be done before implementation of the investment projects proposals. References Oman refineries company, O.Retrieved from en.wikipedia.org/wiki/Oman_Refineries_and_Petrochemical_Company_(ORPC) Panorama. (2015, February 28). Chapter 6 - Investment decisions - Capital budgeting. Retrieved from http://www.fao.org/docrep/w4343e/w4343e07.htm Buckley, A. (2006). International capital budgeting. London: Prentice-Hall. Droms, W. G. (2013). Finance and accounting for nonfinancial managers: All the basics you need to know. Cambridge, MA: Perseus Pub. Goddard, G. J., & Marcum, B. (2012).Real Estate Investment: A Value Based Approach. Dordrecht: Springer. Grant, R. (2008). Planning capital investment decisions.ICSA Publishing. Levy, H., &Sarnat, M. (2007).Capital investment and financial decisions. Englewood Cliffs, NJ: Prentice/Hall International. Mock, E. J. (2007). Financial decision-making. Scranton, PA: International Textbook Co. Peterson, D. P., &Fabozzi, F. J. (2006). Capital budgeting: Theory and practice. New York, NY: Wiley. Riahi-Belkaoui, A. (2009). Evaluating capital projects. Westport, CT: Quorum Books. Read More