Theory of Capital Budgeting - Math Problem Example

Part I: Theory 1. Research the topic of capital budgeting in general, and explain what it is, and why it is used. Capital Budgeting is the planning process used to determine whether a firm’s long term investments such as new plant, new machinery, new product etc. are worth pursuing or not. It is the process of selecting the best long term investment proposal which yield the most return over an applicable period of time. In other words, it is investment decision-making as to whether a project is worth undertaking. It is basically concerned with justification of capital expenditure. Its decisions are not equally essential and similar to all companies as its importance varies from company size, type of business, nature of industry and the growth rate of the firm. It is also “Investment Appraisal”. Why Capital Budgeting is used? Capital Budgeting is an important managerial tool. A firm has limited resources whether we consider its capital or assets which have some value in terms of money. Faced with limited resources, management of the firm has to decide about their best long term investment alternative which is economically acceptable and have high returns during an applicable period of time. Management of the firm can follow a sound procedure called Capital Budgeting to evaluate, compare and select from the set of alternatives. It helps to estimate the cash flow, access the cash flow risks, and determine appropriate discount rates, payback values etc. In other words, Capital is the main resource for a firm and Capital Expenditure has very large and significant impact on the financial performance of the firm, so the management has to take proper decisions before any investment and Capital Budgeting is the tool provided to them. 2. Define the time value of money and explain why it is necessary to consider this when making investment decisions. Time value of money is the value of money with the given amount of interest earned over a given amount of time. In simple words, it is a concept which addresses the ways of changes in the value of money over time. It is an essential part of the opportunity cost that will either give the decision maker the incentive or disincentive to bye a capital good. In Capital budgeting, it is a mechanism for investors to find the current value of a capital good against its value in the future. The concept of Time value of money is closely related to interest rate which leads to the discount factor. Why Time value of money is used? The investment decision involves selection between proposed options of capital goods and their replacement decisions. This selection requires judgments concerning future events which are unpredictable. For this one has to consider time and risk. So for that time, we want to know the present value of our money as well as the future value of the invested money that is how much interest we will earn and in case we are investing the current amount of money then are we getting the equal or more profit or benefit from the future amount of that money. It helps in taking decision whether we should invest in new project, in purchase of new machinery or on other capital goods or not. 3. Research the three main methods of capital budgeting. Make sure you specify the name of the method, how it works, an example, and advantages and disadvantages. The three Capital budgeting techniques are: Payback Method, Net Present Value (NPV) Method, and Internal Rate of Return (IRR) Method These methods have their own pros and cons but all the three methods are used to derive a decision to accept or reject the proposal of new investment. Payback Method: Payback method is concerned with the number of years will take to recover an initial investment. It helps in evaluating projects risk and liquidity, faster rate of return and faster recovery of funds. It is calculated as: Payback period = Expected number of years required to recover a project’s cost Example: There are two projects Project A and Project B available for a company, with a life of 6 years each and required a capital of $9,000 each and additional working capital of $1000 each. The cash inflows comprise of profit after tax + depreciation + interest (tax adjusted) for five years and salvage value of $500 for each project plus working capital released in the 6th year. The company has prescribed a hurdle payback period of 3 years. Which of the project should be selected? Project A Project B Investment 10,000 10,000 Cash Inflow 6 years 6 years Year 1 3,000 2,000 Year 2 3,500 2,500 Year 3 3,500 2,500 Year 4 1,500 3,000 Year 5 1,500 3,000 Year 6 3,000 5,500 Answer: Year Project A Cumulative cash inflows of Project A Project B Cumulative cash inflows of Project B Year 1 3,000 3,000 2,000 2,000 Year 2 3,500 6,500 2,500 4,500 Year 3 3,500 10,000 2,500 7,000 Year 4 1,500 11,000 2,500 9,500 Year 5 1,500 13,000 3,000 12,500 Year 6 3,000 16,000 5,500 18,000 Payback Period of Project A = 3 years (cumulative cash inflows = outflows) Payback Period of Project B = 4 years (cumulative cash inflow $9,500) + (10,000-9,500) *12 /3000(where 3000 is cash inflow of year 5) months = 4 Years and 2 Months So, the company should select Project A with a Payback Period of 3 Years as its main rule is to recover the investment as early as possible. Advantages: Easy to use and understand Effectively handles investment risk Good approach when a weak cash-and-credit position influences the selection of a proposal Can be used as a supplement to other techniques, since it indicates risk Business enterprises facing uncertainty – both of product and technology – will benefit by the use of payback method since the stress in the technique is on early recovery of investment. Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recovery of investment. Disadvantages: Ignores the time value of money Does not consider cash flows received after the payback period Does not measure profitability Does not indicate how long the maximum payback period should be Penalizes projects that result in small cash flows in their early years and heavy cash flows in their later years. Does not consider Rate of Return. Net Present Value (NPV) Method: NPV of an investment is the difference between the sum of the discounted cash flows which are expected from the investment and the amount which is initially invested. In other words, it indicates the value which an investment or project will adds to the firm. This is done by measuring all cash flows over time back towards the current point in present time. Computation of Net Present Value Each cash inflow/outflow is discounted back to its present value. Then they are summed for NPV. Therefore NPV is the sum of all terms , where t – the time of the cash flow i – the discount rate( rate of return that could be earned on an investment in the financial market with similar risk.) Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t (for educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus the) investment. The result of this formula if multiplied with the Annual Net cash in-flows and reduced by Initial Cash outlay will be the present value but in case where the cash flows are not equal in amount then the previous formula will be used to determine the present value of each cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose. If… It means… Then… NPV>0 The investment or project would add value to the firm the investment or project proposal should be accepted NPV Read More