Essay: Capital Budgeting Techniques & ICT Advancement's Impact On Markets.

Swiss Technics Ltd, a manufacturer of watches, is considering the selection of one from two mutually exclusive investment projects, each with an estimated five-year life. Project A costs $1,616,000 and is forecast to generate annual cash flows of $500,000. Its estimated residual value after five years is $301,000. Project B, costing $556,000 and with a scrap value of $56,000 should generate annual cash flows of $200,000. The company operates a straight-line depreciation policy and discounts cash flows at 15 per cent per annum.

Swiss Technics Ltd, uses four investment appraisal techniques as following :

• payback period,
• net present value,
• internal rate of return and
• accounting rate of return (i.e. average accounting profit to initial book value of investment).

Compute the appropriate calculations under the FOUR investment techniques mentioned above and give reasons for your investment advice.

Technology advances in the Information and Communications Technology (ICT) sector over the past two decades have reduced the cost of computer chips. How do you think this has affected the market for computer hardware, computer software and typewriters?

Support your answers for each market mentioned above with appropriate diagrams on the market forces of supply and demand.

The process followed by the companies to evaluate their investment projects is known as capital budgeting. The concept introduces some tools and techniques which are been used by the management to measure the financial viability of the proposal, in which investments are require to be made. These methods allows the managers to select the best suitable and feasible project which will produce high returns and be profitable in future. However, choosing an appropriate investment option is always considered as a challenging task for the mangers because it involves allocation of funds and resources that are available with the company. Some projects require huge capital expenditures and in order to avoid any sort of risk, firms uses capital budgeting techniques like NPV, ARR, IRR and payback period method to examine a proposal properly (Ahmed, 2013).

Information and Communications Technology (ICT) sector comprises of computer hardware and software that are currently used by many entities. Various technological advancements are been made in such sector like people are now looking for online laptops, books and other devices, instead of using Personal Computers. However, the rapidly changing technology affects the consumers and industries to a great extent. Due to such advances, the cost of computer chips has reduced over the past two decades which impacted the market of computer software, hardware and typewriters. As far as humans are concerned, people need to educate themselves and others about the fundamentals of information technology so that they can make best use of it.

This report focuses on both the above topics, starting with providing a recommendation to Swiss Technics Ltd. regarding its investment decision in one of the two mutually exclusive projects. The company uses four investment appraisal techniques which are explained later in the report. The second part deals with the explanation of the impact of technology advancement in ICT on computer hardware and software market. In the last, a conclusion is been provided covering the findings of the report.

Swiss Technics Ltd is a company engaged in manufacturing of watches. The management of the enterprise is looking for selecting the best alternative from the available two options for its investment purposes. The company has two projects A and B which are mutually exclusive and required different amount of funds. In order to choose the appropriate one, following appraisal techniques are used by Swiss.

• Payback Period

It is the most common and simplest method used for evaluating an investment project. It basically measures the time taken by a proposal to recover its initial cash outlay. The payback period shows the number of years a proposal will take to generate the future cash inflows and recover the cash outflow made in starting. It gives an idea about the sustainability of the project and helps the managers to decide that whether the project will be profitable in future or not. Usually, the decision criteria for PBP is to compare the calculated figure with the standard payback period of the organization. If the calculated one is more than the benchmark, then management should reject the project and if vice-versa is there, then project should be accepted (Atrill & McLaney, 2009). 

Payback Period (PBP)

In case of Swiss Technics, discounted cash flows are been used to calculate the payback period for both the projects.

Project A

Project B

From the above calculation, it can be observed that Project B has low payback period as compare to Project A. Both the projects have equal lives that is five years. However, as compare to first project, proposal B will take approximately two years and one month to recover the initial investment. Moreover, the outflow of the proposal is low and it will recover the same within the two years of its entire life. So, as per the PBP method, project B should be accepted.

• Net Present Value

It is the most reliable and authentic technique used by the management to measure the profitability of the projects and to identify the present values of the future cash inflows generated by them. NPV is basically the difference between the PV of cash inflows and present value of cash outflows. In other words, it the amount represented by the excess of inflows over outflows (Baker & English, 2011). Calculation of NPV provides accurate results to the managers as it takes into account the concept of time value of money. The decision rule of this method is that, company should accept the project if it’s NPV is positive and higher than zero. It indicates that the projected earnings of a particular proposal are more than its estimated costs. On the other side, if the same is negative and less than zero then the management should avoid investing in the proposal (Bierman & Smidt, 2012). 

The above table shows the calculation of NPV for both the projects. It is been observed that project A has high NPV than project B. As per the calculations, for proposal A the NPV is $ 209727.75 which is more than the NPV of $ 142272.92, as reported for project B. According to the decision rule of the method, the company should go for project A as it will generate high and positive returns in future. The cash inflows incurred are positive and sufficient enough to make profits and cover the initial investment. So, it will be recommended that Swiss should invest its funds in first project as per the NPV decision criteria.

• Internal Rate of Return

It is also one of the capital budgeting technique which is used to estimate the profitability of the investments made in certain projects. It is a discounting rate where the net present value of a proposal is zero. In other words, the PV of cash inflow is equal to PV of cash outflow. Generally, projects having high IRR are considered to be more suitable than the one with low rate (Brigham & Houston, 2015). The method is used for providing ranks to the multiple projects and choosing the one with the highest IRR. However, it is very difficult to calculate the IRR as it requires hit and trial technique and monotonous calculations. Usually, the calculated IRR is compared to the cost of capital or the required rate of return and if the rate is higher than the cost of capital then the project is profitable, otherwise reject the proposal (Gotze, Northcott & Schuster, 2016).

Net Present Value (NPV)

From the above calculations, it can be interpreted that IRR for project B is 25% which is higher than the IRR of project A with 20%. It is observed that despite of having high NPV, proposal A has low IRR and longer payback period as compare to the second option. So as per the decision rule of this method, proposal B should be accepted as it has high IRR than the other one.

• Accounting Rate of Return

It is also known as average rate of return as it involves the average of two components namely net income and initial investment. This technique measure the amount of return or profits expected from an investment. The formula for calculating ARR is to divide the average income with average investment (Borgonovo, 2017). The method does not consider the time value of money as a result of which management cannot derive reliable outcomes. Just like IRR, it also used as a measure to compare multiple projects having mutually exclusive investments. However, ARR does not takes into account the increased risk of long term projects and the fluctuations in the projects held for long term (Daunfeldt & Hartwig, 2014).

Project A

Project B

The similar trend is been noticed in the ARR of proposal B as it is more than the ARR of project A. in case of Swiss Technics Ltd, the rate of project B is higher which means it will generate high profits as compare to the first project. Although the average income and investment of first project is more but still the second option will be generating profits at higher rate. Therefore, according to this method, project B should be accepted (Venkatesh & Gugloth, 2017).

After analysing both the proposals from the perspective of above four techniques, it will be recommended to the company to invest their funds in project B. Reason being, it has low payback period, high IRR and ARR whereas the project A only has high NPV. Although, net present value technique is the reliable method but while selecting an investment proposal, other factors are also required to be considered. It will be beneficial for Swiss to make invest in Project B as it will recover the initial outlay within two years and will generate profits at high rate. However, it is not as profitable as Project A because of the low investment made in it. Moreover, the difference in NPV of both the projects is not very much significant and it will be okay if company goes for second option rather than investing in first. So, it can be concluded that apart from profitability, managers need to consider other factors like feasibility and viability also while taking decisions related to investments (Shapiro, 2008). 

Internal Rate of Return (IRR)

The advancement of technology in information and communication technology sector has impacted many industries and markets positively and negatively. The technological advances has left a significant impact on the three main markets namely computer hardware, software and typewriters. The supply and demand of the products are highly influenced by the innovation and introduction of new technologies in the sector. Following is the explanation how the advancements have impacted the three markets.

• Hardware  

Due to the developments in the technology, the cost of computer chips are reduced which directly impacted the cost of producing computers and other hardware. The reduction in cost of chips has lower down the cost of production, providing the firms with an opportunity to earn more profit by selling their products at the same price. In other words, lower the cost, higher will be the output (Econport, 2006). In such situation, the supply of hardware products increases as the companies will be able to supply more in the market in order to earn high profits. Such upsurge can be noticed in the below diagram.

Initially the firm was operating at equilibrium point but as and when the cost of computer chips declined, the supply curve shifted towards right direction from S1 to S2. This indicated that quantity supplied for computers increases when the prices of the same reduces. As a result of which, there are more surplus of computers in the market because the supply is more than the demand. It can be observed that prior to the shift in the curve, the areas for producer surplus are B+E and after the shift the surplus area is E+F+G whereas the consumer surplus increases from A to A + B + C + D.

Considering the demand curve, as per the law of demand there is an inverse relationship between the price of a commodity and its quantity demanded. When the price goes down, the demand goes up and vice-versa happens. In this scenario, the price of computers falls which increases its demand in the market. This causes a downward movement in the demand curve, creating a new equilibrium point. At this stage, there will be low prices and high quantity of computer hardware at S2. So, it can be said that reduction in cost of computer chips affected positively to the hardware market as it increases the supply of products and allow the companies to make profits at low cost (Bouchaud, Farmer & Lillo, 2008).

• Software

Accounting Rate of Return (ARR)

The reduced cost of chips led to the increase in supply of computers which automatically raises the supply for computer software. The price of the computer declines which brings an increase in their demand and supply. In this scenario, the computer hardware and software are complementary products and as per the law when the prices of one falls, the demand for other increases simultaneously. Complementary goods are those products which are been consumed jointly by the consumers and has an inverse relationship between them. For example, petrol and car, bread and butter and many others and according to such concept, when the price of computer falls, the demand for software rises (Delgado, 2003). 

From the above diagram, it can be seen that initially the company was operating at equilibrium point. As and when the price reduces and quantity increases, the demand for software also rises which resulted in the shift of demand curve towards right from D1 to D2. The shift shows the increase in both the price and quantity of computer software. In the software market, the consumer surplus changes from B +C to A+ B and the producer surplus changes from E to C + D + E. This means that changes in technology or advancement in it increases the surplus of producers in the software market. However, the prices of software rises to remove the shortfall of computer software in the market which was caused due to high demand within the sector (Prasch, 2008). 

As far as supply curve is concerned, the law of supply reflects a direct relationship between the prices and quantities of goods. It means higher the prices, higher will be the supply. The upsurge in the prices of software creates an upward movement along the supply curve, forming a new equilibrium point. So, when the firms are operating at that point, there will be an increase in price and quantity both. Overall, it can be said that the lower prices have positively impacted the computer software market, leading to the rise in the supplies, prices and surplus (Principles of Economies. 2018).

• Typewriters

Computers and typewriters are basically substitute goods which compete each other. The goods which have direct relationship and are used at each other’s place are known as substitute products. Changes in the price of one do affect the demand of others. In other words, increase in price of one product will reduce its demand but it will increase the demand of its substitute product. Therefore, it can be said that fall in price of computers will reduce the demand of typewriters in the market. As the price reduces the consumers will purchase more computers which eventually affects the market of typewriters. Here, a positive relationship operates where the reduction in computer’s price will reduce the typewriter’s demand. The below diagram shows the shift in the demand curve towards left (Ball & Seidman, 2011).

Impact of Technology Advances on Markets

It can be seen in the diagram that as the demand curve shifted from D1 to D2, the equilibrium price and quantity of typewriters declines. The area of consumer surplus changes from A + B to A + C and producer surplus reduces from C + D + E to E. This shows a loss to the producers and a setback to the typewriters market. However, the surplus causes the disequilibrium in the market and to remove the same, the prices of typewriters decreases. As a result the price falls from P1 to P2 and according to the law of supply, as and when the prices increase the supply of the goods also rise. In this case, the price of typewriter reduces which makes its supply to fall, showing a downward movement along the supply curve.  So overall, it can be said that the change in technology does not prove to be favourable for the production of typewriters as it reduces both the price and demand of the product. On a whole, technology advancement has a negative impact on the typewriter market (Welch & Welch, 2016). 

Conclusion 

From the above report, it is concluded that it is very important for the management to use appropriate capital budgeting techniques for evaluating their investment proposals. It will help them to select the best project which will be feasible, viable and profitable for the company in future. Application of these methods indicates all the financial and non-financial aspects of the investment projects. In case of Swiss Technics Ltd, the company should invest in Project B as it will be more profitable and suitable to it. It has high IRR, ARR and low payback period which implies that high profits will be generated in future with the requirement of low investment.

The second part concludes that changes in the technology advancements and reduction in the prices of computer chips do affect the markets of hardware, software and typewriters. The demand and supply of computers and its software increases with the reduction in the cost of production and prices of the products. However, such change has a negative impact on the typewriters market because the demand of the product reduces along with its price.

References 

Ahmed, I.E. (2013). Factors determining the selection of capital budgeting techniques. Journal of Finance and Investment Analysis, 2(2),77-88.

Atrill, P. & McLaney, E. (2009). Management accounting for decision makers (4^th ed.). England: Pearson Education.

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

Ball, M. K., & Seidman, D. (2011). Supply and demand. New York: The Rosen Publishing Group.

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

Borgonovo, E. (2017). Sensitivity Analysis: An Introduction for the Management Scientist (Vol. 251). Switzerland: Springer.

Bouchaud, J.P., Farmer, J.D. & Lillo, F. (2008). How markets slowly digest changes in supply and demand. Retrieved from: https://arxiv.org/pdf/0809.0822.pdf

Brigham, E.F. &Houston, J.F. (2015). Fundamentals of Financial Management. Cengage Learning.

Daunfeldt, S.O. & Hartwig, F. (2014). What determines the use of capital budgeting methods?: Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4),101-112.

Delgado, C.L. (2003). Fish to 2020: Supply and demand in changing global markets 1^st ed. Malaysia: WorldFish.

Econport, (2006). Factors Affecting Demand Retrieved from: https://www.econport.org/content/handbook/Demand/Factors.html 

Gotze, U., Northcott, D. &Schuster, P. (2016). INVESTMENT APPRAISAL (2nd ed.). New York: SPRINGER-VERLAG BERLIN AN.

Prasch, R. E. (2008). How markets work: supply, demand and the'real world'. UK: Edward Elgar Publishing.

Principles of Economies. (2018). Demand, Supply, and Equilibrium in Markets for Goods and Services. Retrieved from: https://opentextbc.ca/principlesofeconomics/chapter/3-1-demand-supply-and-equilibrium-in-markets-for-goods-and-services/ 

Shapiro, A. C. (2008). Capital budgeting and investment analysis. India: Pearson Education.

Venkatesh, M., & Gugloth, D. (2017). A Review of Capital Budgeting Techniques. International Journal of Economics and Management Studies Retrieved from https://www.internationaljournalssrg.org/IJEMS/2017/Special-Issues/ICEEMST/IJEMS-ICEEMST-P102.pdf 

Welch, P. J., & Welch, G. F. (2016). Economics, Binder Ready Version: Theory and Practice. USA: John Wiley & Sons.