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BAO5534 Business Finance

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  • Course Code: BAO5534
  • University: Victoria University
  • Country: Australia

Questions:

  1. Why are capital budgeting decisions important for a business firm? Discuss their concept and significance

  2. Discuss the types of information generally required for evaluating the capital budgeting decisions of a firm from a financial standpoint.

  3. What is meant by the Net Present Value (NPV) technique? Discuss its key assumptions and calculation methodology (including an estimation of the discount rate).

  4. Explain the concept of the Internal Rate of Return (IRR). What is the criterion generally used by firms while accepting or rejecting a capital budgeting project on the basis of the IRR technique?
 

Answers:

Introduction

The managers of the entity are accountable for the conduct of the business operations in a manner that leads to the wealth maximization of the shareholders as well as the consideration of the interests of the other stakeholder groups within the business entity. Further to note, that business conduct within an organisation involves undertaking of varied strategic decisions in the areas of the operating, investing and financing activities (Bierman and Smidt, 2012).

Capital budgeting decisions: Concept and significance

One of the key issued faced by the finance managers is to decide as to where to invest the funds of the organisation with the hopes of gaining returns in future periods. Thus, in light of the above issue lies the meaning and the significance of the term “Capital Budgeting.” Capital Budgeting is defined as the planning process that is conducted for the determination of worth of long-term investments of the business which may be related to either purchase of assets, expansion of a project, capturing a market share or others (Baker and English, 2011). It has been also denoted as allocation of the scarce economic resources of an entity to yield efficiently amid the available opportunities in the market. Thus, focus of the process is generally the long term investments for two reasons. These are also referred to as the investment appraisal decisions. Firstly, it is to be noted that the long term investment these decisions involve a huge amount of capital and other resources. The second reason is that the long term investments are irreversible business decisions. Thus, once the projects have started or capital amount has been invested in a capital asset, there are long term impacts for following year, and these cannot be ceased (Brigham and Houston, 2012). Thus, the key features of the capital budgeting can be elaborated as follows.

Long term effect: The outcome of the evaluation process renders long term impact on the operations of the entity. It is essential to note that the growth rate of the business is influenced by the said process. For instance, over-investment in assets of an organisation can lead to issues of cash flow and shortage in the capital. On the contrary, the insufficiency in the investments holds the potential to hamper the growth of business.

Influence on the competitive position of an organization: Not only does the capital budgeting process aids in determining the worthiness of capital investment, but also helps in the estimation of the future profits and expenses. Thus, this influences the market share as well as the competitive position of an entity.

Cash forecasts and maximization of the shareholder wealth: The process additionally aids in the planning of the short term assets including the cash flows and allows business conduct smoothly. Further it can be stated that the efficiency of the process leads to safeguarding the interests of the shareholders.

It is to be noted that the capital budgeting decisions are of many types, and each of one is undertaken in some or the other forms in the business organisation.

  1. Expansion decisions: These deals with the expanding the existing production processes so that the additional demands in the markets can be fulfilled. In addition, the new markets can be trapped by using the disadvantage of the already existing economies of scale.
  2. Replacement decisions: These deals with the replacement of the existing assets of the organisation such as the plant, machinery, building, or others. This is undertaken to for the avoidance of the repair charges and including new technological advancements in the production processes. Thus, capital budgeting aids in achievement of efficiency of business operations and reducing the cost of products (R?hrich, 2014).
  3. Buy decisions:  These involve decision as to whether to hire or lease an asset in light of the costs involved.
 

Evaluation in capital budgeting decisions

The evaluation of the investment decision is a comprehensive process and requires a a step by step procedure as elaborated below (Tulvinschi, 2014). There are various components involved in the capital budgeting calculations. The prime component is the appropriate discounting rate or the cost of capital. This is used in the techniques recognising the time value of money like NPV, IRR and Profitability Index. There are various methods used such as the Weighted Average Cost of Capital (WACC) and often the cost of equity as determined by the Capital Asset Pricing Model (CAPM) model is used. Apart from this, there is an estimation of the revenues and costs over the useful life of years. The steps involved in the capital budgeting decision are listed as follows.

  • Defining the objectives of the organisation, long term as well as the immediate goal.
  • Researching and identifying the investment opportunities in the market.
  • Using the finance budget and the non-qualitative factors to classify the projects for further appraisal. These are the legal, environmental, political factors.
  • Determining the cash inflows and outflows, useful lives, risk involved, inflation and taxation rates, and rate of return of proposal.
  • Application of capital budgeting techniques and selecting the projects.
  • Monitoring the project after implementation.
 

Net Present Value (NPV)

There are varied capital budgeting techniques that are used by the financial managers for the evaluation of a proposal. One of the most fundamentally sound and renowned technique is that of the Net Present Value. The relevance of the technique lies in the fact that the NPV gives due weightage to the notion of time value of money (Scott, 2012). The methodology of the technique involves is to use an appropriate discount rate for discounting of the cash inflows and outflows, arising out of a proposal at different points of time and comparing the same to find the net values of it. The following formula represents the NPV computation (Baker and English, 2011).


where:

CF0 = Capital expenditure at year 0

CFi = Annual cash flows from year i

k = Cost of capital or discount rate

n = number of years.

It is to be noted that there are certain underlying assumptions in the technique as listed below. First assumption is that there will be an immediate generation of cash from the proposal which will be furhther subjtectd to reinvestment (Gallo, 2014). The rate of such reinvstment has been asssuemd to be same as the discount rate used previously. The second assumption is that the annual cash flows arise at the end of each period.

When the project under consideraito is the sole one in consideration, a positive NPV leads to selection of the project and vice versa. A positive NPV is representative of the fact that  the discounted amounts of the cash inflows are more than the discounted amounts of the cash outflows (Gray, Larson and Desai, 2011). However, when there are more than one mutually exclusive projects in consideration, it is recommended to choose the project with the highest NPV subject to other non financial factors.

 


Following is an example of the peformance of the technique.

Suppose there is a company that is considering to purchase an asset. The cost of the asset is $  80000, followed by economic life of 6 years, and there is zero salvage value at the end.. In addition, the incremental annual cash inflow arising out of the asset purchase and production efficienct is $ 30000 per year. The cost of capital has been worked out to be 20 %. The computation of NPV is depicted below:

Year (s)

Description

Amount in AUD

PVF @ 20 %

Present Values

0

Initial expenditure

-80000

1.000

-80000

 1-6

Incremental cash flows

30000

3.3255

99765.30

 

 

 

NPV

19765.30

 

Hence, in the above instance, the NPV has been worked out to be positive, and thus it is beneficial to invest in the said asset.

As stated in the previous parts, the key advantage is the usage of the time value of money Second advatage of this method is that the, pre and post project cash flows are given consideration in the calculation. However, apart from the benefits it is essential to note tha the computation of the NPV depends majorly on the appropriate cost of capital determination (Pogue, 2010). If such determination is not carried out efficiently, the outcomes could be misleading. In addition there are varied other complexities in the technique and person with expertise only can perform as well as understand the same.

 

Internal Rate of Return (IRR): 

The yet another capital budgeting technique is of Internal Rate of Return or the IRR method whose underlying concepts are similar to that of the NPV method. The internal rate of return which when discounts the cash flows arsing out of a proposal leads to the zero NPV. This means at this rate, the Present valus of the cash inflows are equal to the present values of the cash outflows. It also implies the economic rate of return which leads to the determination of the interest earned on varied time periods on the capital invested in the project (G?tze, Northcott and Schuster, 2015). In context of the lending, it is also denoted as the effective interest rate earned on the investment. Thus, in simple words it is the annualized effective compounded rate of revenues and costs involved in the proposal. The presentation of formula of the IRR has been done as follows.

Where dl = lower cost of capital and

dh = higher cost of capital.

Thus, if the internal rate of return  of a project appraisal is more than the already determined hurdle rate, the recommendation is to accept the proposal and vice versa (Lane and Rosewall, 2015). When there are more than one project in the consideration of the management, the one with the highest IRR, that the one with the most difference between hurdle rate and IRR is preferred over the others. An example of the IRR computation is presented as follows.

An example is considered where a company is contemplating the purchase of a machine the price of which is $30000. In addition, the salvage value has been determined to be $10,000 The economic life of the machine has been determined to be 3 years. Further, it has been estimated by the management that the incrmental cash that would be generated would be $ 12000 for 3 years. The determination of the IRR has been done as below represented.

Net present value at 25% = (1456)

Net present value at 10% = 7342

Thus, the IRR using the formula discussed above is workrd out to be 21 %

The key benefit of the usage of the technique is that the Time value of money is considered here as well.  However, the major weaknesses is that a project can have multiple IRRs depending upon the cash flow patterns (Goyat and Nain, 2016). Further, the results are not presented in absolute form, which means the exact benefit out of a proposal cannot be worked out.

Conclusion

Hence, it can be concluded from the above discussions that the capital budgeting decisions are key aspects of the business functioning as part of the long term investment decisions. These are crucial for the companies because of the capital and other resources involved. The techniques of the NPV and IRR have been studied at length to conclude these are useful from the point of view of consideration of the time value of money.

 

References

Baker, H. K., and English, P. (2011) Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. New Jersey: John Wiley & Sons Inc.

Bierman Jr, H., and Smidt, S. (2012) The capital budgeting decision: economic analysis of investment projects. 9th ed. Oxon: Routledge.

Brigham, E. F., and Houston, J. F. (2012) Fundamentals of Financial Management. Boston MA: Cengage Learning. 

Gallo, A., (2014) A refresher on net present value. Harvard Business Review. [online] Available from: https://www.cogencygroup.ca/uploads/5/4/8/7/54873895/harvard_business_review-a_refresher_on_net_present_value_november_19_2014.pdf [Accessed on 23 May 2020].

Goyat, S., and Nain, A. (2016) Methods of Evaluating Investment Proposals. International Journal of Engineering and Management Research (IJEMR), 6(5), p. 279.

G?tze, U., Northcott, D., and Schuster, P. (2015) Investment Appraisal: Methods and Models. 2nd ed. London: Springer, p. 63.

Gray, C. F., Larson, E. W., and Desai, G. V. (2011) Project Management. The Managerial Process. 4th ed. New York: Tata McGraw Hill Education Pvt. Ltd.

Lane, K., and Rosewall, T. (2015) Firms’ investment decisions and interest rates. Reserve Bank of Australia Bulletin. June quarter.

Pogue, M. (2010) Corporate Investment Decisions: Principles and Practice. New York: Business Expert Press.

R?hrich, M. (2014) Fundamentals of Investment Appraisal: An Illustration based on a Case Study. Boston: Walter de Gruyter GmbH & Co.

Scott, P. (2012) Accounting for Business: An Integrated Print and Online Solution. Oxford: Oxford University Press, p. 342.

Tulvinschi, M. (2014) The Profitability – An Attribute of Financial and Accounting Nature in the Decision to Invest. USV Annals of Economics and Public Administration, 14(1), p. 171.

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