Table of Contents
Capital Budgeting and Techniques.
Net Present Value
The function of capital budgeting has found an important application in the contemporary society. Organizational managers employ capital budgeting techniques to maximize shareholder value. This report was developed to determine the tools used by organizations and the theoretical correctness of the tools. Characteristics and influence of the decision makers were considered to find the best capital budgeting tool. This research focused on the general business entities. This research is a structured literature survey. The gathered information provides information on available literature on the topic of study, thus adequate understanding. Available literature presents the techniques of capital budgeting that executive managers use to evaluate organizational projects. The merits and demerits of these techniques were noted.
This report’s findings show that companies use the Net Present Value, Internal Rate of Return, Profitability Index, Discounted Payback Period, and Payback Period when conducting project evaluation. However, many users tend to prefer Payback Period, Internal Rate of Return, and Net Present Value to assess the viability of a proposed project. Nonetheless, Net Present Value was seen to be the most popular tool and as a result, theoretically correct. Net Present Value is widely used because it is accurate in considering the time value of money. Net Present Value also adjust for several risk factors. Payback Period is used because of the ease of calculation and comprehension. This research recommends the use of Net Present Value for project evaluation as literature vouches for it as the best tools.
Capital Budgeting and Techniques.
The practice of capital budgeting has found a basic role for companies planning to make investments. In the contemporary society, capital budgeting is an important decision for financial managers. A firm’s strategic plan should be considered in the course of capital budgeting. According to Binder and Chaput (2012), capital budgeting is a delicate process and, therefore, should be practiced in accordance with proven techniques. There are several tools proposed by researchers for capital budgeting. These techniques assist in the determination of the anticipated return from a given project. Some techniques are theoretically superior compared to others however; each has its merits and demerits.
Payback Period is classified as a non-discounted cash flow technique. It is explained as the duration required for working cash surplus brought about by a project to totally equal the investment capital (Parrino & Kidwell, 2011). This technique evaluates the annual earnings since the start of until the accrued incomes equal the asset cost (Binder & Chaput, 2012). The study by Binder and Chaput (2012) has shown that the payback tool is favored because of several reasons. Unlike the other capital budgeting tools, Payback Period is easy to understand, thus, can be used by many organizations. The technique also tends to favor capital investments that remit large initial cash flows. The study also states that the Payback method allows financial managers to cope with risk despite the fact that it does not directly treat risk. Binder and Chaput (2012), state that with Payback Period, a financial manager is allowed to examine the time it will take to return the initial investment. Another advantage of Payback method is its ability to address the capital rationing issue. The associated ease of use allows for decentralization of capital budgeting thus enabling worth items to be considered in the budget.
Despite the numerous advantages, there are highlighted disadvantages of the Payback method. Atrill and Mclaney (2010), observe that the payback technique omits cash flows. Therefore, the method does not consider the subsequent cash flows of a project’s payback period. The method has a tendency to consider the returns of a project only up to the payback period. Additionally, this capital budgeting tool ignores the value of money (Atrill & Mclaney, 2010). The discounted payback period was forwarded as a modification of the payback period.
Net Present Value
This tool presents the variation of the current value of cash inflows and the outflows (Graham & Harvey, 2011). Evaluation of the Net Present Value of an investment encompasses measuring the future net cash flows of a project, suitably discounting the cash flows, and deducting the initial net investment outlay (Binder & Chaput, 2012). This technique has been accorded several advantages. The method considers time value of a capital project by taking discounts from the cash flows (Awomewe & Ogundele, 2010). In their study, the researchers argue that because the computation of Net Present Value is based on anticipated cash flows from an investment, therefore, bookkeeping practices like non-cash expenditures and depreciation do not influence the decision. Furthermore, as compared to other methods, Net Present Value tool uses all the cash flows of the investment (Awomewe & Ogundele, 2010).
Although the Net Present Value technique has been given a superior position to other tools by researchers, it demonstrates some drawbacks. The technique also has some inconsistent behavior. Particularly, it is possible for the Net Present Value to increase with an increase in discount rate, or fall with a decrease in the discount rates (Parrino & Kidwell, 2011). This inconsistency makes Net Present Value technique to be less useful for evaluation of risky and technical projects. Methodically, Net Present Value underestimates most projects. This is due to the robust intrinsic postulations made that no certain decisions would have to be made in the preceding years after the project decision (Awomewe & Ogundele, 2010).
Profitability Index is defined the fraction of the present benefits of prospect cash flows to the tangible cash outflow (Mao, 2014). The technique has been attributed with simplicity, a measure of profitability, and adjustment to risk among other benefits (Bhandari, 2009). The author forwards several arguments for the Profitability Index technique. For instance, he asserts that the method takes into account the size of a capital investment and duration of the associated cash flows over the lifetime of the project. More so, Profitability Index provides a relative appraise of the present value for each unit currency of definite investment. Mao (2014) writes that this method is easy to understand and also adjusts for risk.
Bhandari (2009) sees Profitability Index as a difficult method to use particularly when defining the profitability of a project because the technique does not have an intrinsic appreciation of rate of return. Additionally, the technique might yield undesired results when reciprocally exclusive investments with varied sizes are taken into consideration (Bhandari, 2009).
Another common technique used for capital budgeting is the Internal Rate of Return. The tool is the markdown rate at which the current value of a proposed project outlays equals the present value of the anticipated cash income on that investment (Awomewe & Ogundele, 2010). The Internal Rate of Return takes into account time worth of money by calculating the current value of an investment’s cash flows (Awomewe & Ogundele, 2010). This technique is difficult to understand as returns are stated in percentage. Nonetheless, the Internal Rate of Return develops assumptions that make awful projects look beneficial (Mao, 2014). The method postulates the average cash flows earn same rates of return as the primary project, therefore, creating idealistic returns to the shareholders.
Discounted Payback Period is a technique that determines the period wherein an incremental net present value of an investment’s cash flows equals zero (Bhandari, 2009). The technique is usually favored in instances where the lifetime of a project is not defined because of dynamics in regulations, competition, and user preferences (Bhandari, 2009). The researcher has presented the technique as a better method to use in capital budgeting than Profitability Index and Internal Rate of Return. Discounted Payback Period is easy to determine and comprehend (Bhandari, 2009). The technique ensures profitability by taking into discounting cash flows and considers the time worth of money. Nevertheless, Graham and Harvey (2011) criticize the technique based on some drawbacks. For example, the method does not account for cash flows period after the Discounted Payback Period. Moreover, the method assumes the realistic reinvestment of the intermediate cash inflows.
The literature study has highlighted the pros and cons of the various capital budgeting measures. The value of shareholders is developed when the present value of the money inflows is more than the previous cash outlay. This assertion demonstrates the significance of the capital budgeting process as a function of managers. Despite the availability of many decision tools, this literature survey rates the Net Present Value method as most superior as it satisfies six of Bhandari’s qualities: measure of profitability, adjustment to risk, assumes the realistic reinvestment of transitional cash inflow, account for all cash flows, consistency with wealth maximization, and time value for money. The use of computers has lessened some of the difficulties associated with the technique. According to the researcher’s opinion based on the literature survey, the Net Present Value method qualifies to be theoretically correct as it satisfies many Bhandari’s traits of an effective capital budgeting method.
Awomewe, A. F. and Ogundele, O. O. 2010. The importance of the payback method in capital budgeting decision. MBA Thesis at Blekinge Institute of Technology.
Atrill, P. and Mclaney, E. 2010. Management accounting for decision makers. (6th Edition). Prentice Hall: Financial Times, London.
Bhandari, S.B. 2009. Discounted payback period- some extensions. Proceedings of ASBBS. Volume 16 Number 1 http://asbbs.org, accessed 30 March 2016.
Binder, J.J. and Chaput, J.S. 2012. A positive analysis of corporate capital budgeting practices. Review of Quantitative Finance and Accounting 6(3): 245-257.
Graham, J. R. and Harvey, C. R. 2011. The theory and practice of corporate finance: evidence from the field. Journal of Financial Economics (60): 187-243.
Mao, J.C.T. 2014. Survey of capital budgeting: theory and practice. The Journal of Finance 25(2): 349-360.
Parrino, R., & Kidwell, D. S. (2011). Fundamentals of corporate finance. Hoboken, NJ: Wiley.
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- M. Sc Environmental Science Marvin Namanda (Author), 2016, Capital Budgeting, Net Present Value and other Business Decision Making Tools, Munich, GRIN Verlag, https://www.grin.com/document/355210