Capital Budgeting Techniques And Evaluation Essay.

NPV and IRR Concept

Management of the company has responsibility to take the managerial decisions that comprise of capital budgeting measurement to select the best option available from the given set of mutually exclusive projects. Capital budgeting decisions are most important and it is based on the cost benefit analysis of individual projects (Baker, 2011).

In this report, various concepts of the capital budgeting and their use in managerial decision making process will be elaborated in detail using the numerical examples. There are two methods in capital budgeting namely, net present value and internal rate of return that provides help while making the decisions regarding the selection of best alternative projects. These two methods are impacted due change in different value in the project, therefore there is need to analyze the projects on the ground of various cost analysis techniques such as sensitivity, scenario, break-even and simulation technique.

The developing of an insight into the concept of NPV and IRR is highly essential for understanding the sensitivity analysis. The methods are used for making investment decisions and analyzing the feasibility of a project. The feasibility of a project depends on achieving positive cash flows relative to the investment made. In this context, the net present value (NPV) is a method used in capital budgeting for determining the profitability realized from projected investments in a project. The investment can be done in the initial stages of a project or at later stages referred to as working capital. The NPV is a most popular discounted cash flow model that incorporates the use of concept of time value of money in assessing the net present value of an investment project. It is one of the most popular capital budgeting techniques that help in selection of rejection of a proposed project such as purchasing a fixed asset or expanding the product base of a business entity (Albrecht et al., 2007).

The NPV is measured through assessing the difference between the present value of cash inflows and the cash outflows. The time series technique is used for measuring the initial value of cash inflows. It helps in determining the value that will be realized by a business undertaking a project by predicting the three possibilities that are, positive, zero and negative NPV of a project. The positive value of NPV is achieved when the present value of cash inflows is more than that of the cash outflows and results in accepting a project. On the other hand, zero NPV indicates that value of cash inflows and outflows is equal to each other resulting in accepting a project. However, negative NPV indicates that value of cash inflow is less that of cash outflows indicating the rejection of a project (Peterson and Fabozzi, 2004). The NPV is calculated through the use of following formula:

Different Cost Analysis Techniques used to Evaluate the NPV and IRR

C_t = present value of net cash inflows at a time period t

C_o = overall cost of total initial investments

r=discount rate

t=number of time-periods

The IRR refers to as internal rate of return is a capital budgeting technique that assesses the profitability of an investment. The IRR is referred to as a discount rate at which the net present value of cash inflows realizing from a project becomes zero. The IRR method is largely being used by the investors for estimating the attractiveness of a project. The acceptance or rejection of a project depends on whether the IRR is greater or less than the required rate of return. The project is accepted if IRR is greater otherwise it is rejected. The formula for calculating IRR is depicted as:

IRR= R (L) + NPV (L)*[R (H)-R (L)] / [NPV (L)-NPV (H)]

Where:             R (L) = Lower discount rate

R (H) = Higher Discount rate

NPV (L) = Net present value at lower discount rate

NPV (H) = Net present value at higher discount rate

However, IRR is regarded to be a better approach for determining the feasibility of a project as it the method is more objective-based as its result is entirely based on appropriate cash flow figures rather than selecting random discount rates. Also, the method helps in determining the project feasibility through undertaking its comparison with inflation, current interest rates and other possible options of financial investment (Juhász, 2011).

Sensitivity analysis is most important technique of the cost analysis as it helps in evaluating project outcomes under different conditions. Under the sensitivity analysis the dependent variable are put to test under different conditions (Moyer, McGuigan and Rao, 2014). Every project is vulnerable to three main conditions namely, worst condition (Pessimistic situation), current condition (Expected situation) and good condition (Optimistic situation). So it is important to work the performance of the project under all three situations. Motive is to check how the independent variables of the NPV or IRR calculation process react to the change of dependent variables (Weygandt, Kimmel and Kieso, 2009).

Sensitivity analysis notes down the change in the outcomes of the NPV and IRR due to change in any one variable such as initial investment, rate of cost of capital, Cash flows values or fixed expenses and many more  (Otley and Emmanuel, 2013). There are mainly three main steps that need to follow while making calculation for the sensitivity analysis. They are given as under:

• There is need to detect and note all the dependent variables under the NPV or IRR method such as cost of initial investment, rate of cost of capital etc.
• In the second step, relationships between the dependent variables that are found in the first have to consider so that changes can be made according.
• In the last step, all the changes to the independent variables and the outcomes under NPV or IRR are checked and according the project is selected (Smit, 2007)

Sensitivity Analysis

Numerical example: In this example all three conditions have been consider: worst condition (Pessimistic situation), current condition (Expected situation); and good condition (Optimistic situation). For example a project is selected and changes have been made with three main dependent variables. They are:

• Change in value of initial investment
• Change in fixed expenses
• Change in value of cash inflows

Scenario analysis is almost same as the sensitivity analysis but this technique is more useful as it consider the particular situation unlikely the three conditions in the sensitivity analysis. Situation can be occurred due to change in management policies, technological change or competition level. There are many other factors that creates situation that force to change in outcomes of the value of NPV and IRR.

Scenario analysis can be easily understood with the following example. In this example situation is taken where there is increase in competition level that has change level of sales. Initial cash investment: $250000. Rate of cost of capital: 8 % and years of investment will be 5 years.

The technique of simulation analysis is used for measuring the project uncertainty by assessing the market conditions. There exist potential risk in a project due to the fluctuations in the market conditions due to presence of forces such a s competition, government pressure, technological, climatic  and economical changes. Thus, it is extremely important for a project manager to determine the project risk on the basis of the market forces at the time of selecting or rejecting a project proposal. One of the most famous simulation technique used by the project managers is Monte-Carlo Simulation method. The method incorporates the section of random variable through computing technology and developing a table against each of selected random variable. The process helps in determination of the NPV and IRR of a project (Bierman and Smidt, 2014).

The break-even point of a project refers to a situation where it provides zero rate of return and the profitability realized equal to the net investment made. Thus, as such a business realizes no loss or profit from undertaking a project. The breakeven analysis is mainly used by business entities for estimating at which a project will realize its break-even point and thus adopting appropriate measures so that it can easily achieve its break-even point. The business entities are requiring realizing the break-even point as early as possible for maintaining their competitive position in the market place (Moles, Parrino and Kidwell, 2011).

Conclusion

Thus, it can be summarized form the overall discussion held in the report that the capital budgeting techniques plays an important role in the decisions relating to the acceptance or rejection of a project. The managers should determine the feasibility of a project on the basis of the results obtained through the use of methods such as sensitivity, simulation, scenario, IRR and NPV. 

References

Albrecht, W. et al. 2007. Accounting: Concepts and Applications. Cengage Learning.

Baker, H.K. 2011. Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. John Wiley & Sons.

Bierman, H. and  Smidt, S. 2014. Advanced Capital Budgeting: Refinements in the Economic Analysis of Investment Projects. Routledge.

Juhász, L. 2011. Net Present Value Versus Internal Rate of Return. Economics & Sociology 4 (1), pp. 46-53.

Moles, P, Parrino, R. and Kidwell, D.S. 2011. Corporate Finance. John Wiley & Sons.

Moyer, C., McGuigan, J. and Rao, R. 2014. Contemporary Financial Management            . Cengage Learning.

Otley, D. and Emmanuel, K. 2013. Readings in Accounting for Management Control. Springer.

Peterson, P. and Fabozzi, F. 2004. Capital Budgeting: Theory and Practice. John Wiley & Sons.

Smit, P.J. 2007. Management Principles: A Contemporary Edition for Africa. Juta and Company Ltd.

Weygandt, J., Kimmel, P. and Kieso, D. 2009. Managerial Accounting: Tools for Business Decision Making. John Wiley & Sons.