Sophisticated Vs. Naive Selection Techniques In Capital Budgeting Essay.

Part A.  

“The financial methods of capital budgeting can be grouped into two basic classes – sophisticated and naive selection techniques. Sophisticated techniques are those that consider the risk adjusted discounted net cash flows expected from a project. In contrast, naive methods generally do not use cash flow.”  

Your evaluation may wish to consider the following points, together with any other points you consider relevant.

• Summarise the recent trend (not more than 10 years) of literature research findings and direction in capital budgeting.
• In the context of above explanation by Haka et al (1985), critically evaluate techniques which may be used to assist in the capital budgeting decision-making process.
• By including relevant empirical evidence that offers critics and proponents of relevant research studies in capital budgeting, critically evaluate their potential usefulness for managers responsible for taking investment decisions in the context of wealth creation. 

Part B  

“The efficient markets hypothesis is simple in principle, but remains elusive. Evolving from an initially puzzling set of observations about the random character of security prices, it became the dominant paradigm in finance during the 1970s. During its heyday, the efficient markets hypothesis came to be supported by a growing body of empirical research demonstrating the difficulty of beating the market, whether by analysing publicly available information or by employing professional investment advisors. Testing for market efficiency, however, is difficult.” 

Your evaluation may wish to consider the following points, together with any other point you consider relevant.

• Summarise the recent trend (not more than 10 years) of literature research findings and direction in “efficient market hypothesis”.
• Is market efficiency testable?
• Is it possible for an investor to make excess return consistently?
• The behavioral challenge to market efficiency • Integration of empirical evidence that offers critics and proponents of the efficient market hypothesis  

Recent Trends

Capital budgeting is an investment appraisal technique which is used by the organizations and the investors to analyze the various investment opportunities. This technique is used for evaluate the long term investment such as replacement of old machineries, buy new machineries, new products, new plants and research development etc. For evaluating the best project, various capital budgeting techniques are available. Every capital budgeting could offer different result as the different bases could be evaluated. Many formal methods are used in the capital budgeting process such as accounting rate of return, profitability index, net present value, average accounting return, payback period, internal rate of return etc. (Bodie, Kane and Marcus, 2014).

Capital budgeting is the procedure in which an organization analyzes and measures the potential expenses and income of the project in a large manner. These investment, returns and expenditure include various projects such as investing in long term venture and building a new plant. In this report, various studies have been studied and the importance and the critics of the capital budgeting have been studied so that a better conclusion could be get.

According to the given lines in case, capital budgeting could be grouped into 2 basic parts which as sophisticated selection techniques and naïve selection techniques. Sophisticated technique is those capital budgeting methods which take the concern of the discounted cash flows of the investment to make a better decision. These techniques are quite helpful for the management of the company to analyze the bets project on the basis of the statistical data (Hamid et al, 2017). At the same time, naïve technique is those capital budgeting methods which take the concern of the information rather than the cash flows of the investment to analyze the best project for the company. These techniques are quite helpful for the management of the company to analyze the best project on the basis of the information and non financial data. Both the techniques are quite useful for the company (Hayward et al, 2017).

According to the history of the company, currently various changes have taken place in the process and the methods of the capital budgeting. From Irving Fisher (1907) to current times, a huge concentration on the sophistication and progressive development of investment appraisal techniques has taken place. Capital budgeting is quite crucial for an organization to maintain and analyze the investment opportunity. However, various organizations still approach the capital budgeting methods as an ad hoc fashion (Dellavigna and Pollet, 2013). Organizations consider the capital budgeting methods as a financial progression rather than the method to analyze the strategic decision which could lead the business into failure.

Capital Budgeting Techniques

In an economy where data could be driven very easily, collecting the good information is crucial. Especially, in capital budgeting methods, it becomes very important. Further, it is the best way for an organization to collect the information about various investment opportunities which are available in the market to administer that which investment opportunity would offer the highest return to the company and assist the company to maintain the good performance in the company (Amos et al, 2015).

According to the current trends, the naïve technologies are used by the company most rather than the sophisticate technologies as it is not easier for an organization to collect, analyze and evaluate all the financial figures related to the investment project of the company (Mbabazize and Daniel, 2014).

From the given statement of Haka et al (1985), it has been found that capital budgeting could be grouped into 2 basic parts which as sophisticated selection techniques and naïve selection techniques. Sophisticated technique is those capital budgeting methods which take the concern of the discounted cash flows of the investment to make a better decision. At the same time, naïve technique is those capital budgeting methods which take the concern of the information rather than the cash flows of the investment to analyze the best project for the company. Following are some of the capital budgeting techniques:

1. Net present value:

Net present value is the total difference among the total net cash outflow of the investment option and total net cash inflow of cash outflow. Net cash flows are calculated on the basis of the discounted cash flows and thus it is one of the sophisticated capital budgeting techniques which assist the organization to evaluate that which investment opportunity is the best one for the organization point of view (Bas, 2014). It evaluates the total profit which could be earned by the organization through that investment proposal. The positive next cash flow is better than the negative cash flows.

2. Internal rate of return:

Further, internal rate of return is the technique which measures the profitability of potential investment proposal. Internal rate of return is calculated a discount rate which makes the net present value of entire cash flows from a specific project zero. It evaluates the discount rate which is quite helpful for the organization to make better decision that whether the proposal must be accepted or not (Erdem, 2017). The internal rate of return expresses that a project must be accepted only when the discount rate is higher than the cost of capital of the company.

3. Payback period:

Capital Budgeting Critics

More, Payback period is the technique which measures the total time period in which the invested amount could be get back by the investor again. Payback period is calculated through evaluating the cumulative cash flows and mainly, it is calculated to analyze the total time. It evaluates the total payback period which is quite helpful for the organization to make better decision that whether the proposal must be accepted or not. In this technique, 2 or more projects are evaluated to make a better result. The proposal with less payback period must be accepted by the investors (Andor, Mohanty and Toth, 2015).

4. Average rate of return:

More, average rate of return is the technique which measures the profit of the investment. Average rate of return is calculated through dividing the total net profit by number of years by initial cost and mainly, it is calculated to analyze the total return. It evaluates the total average rate of return which is quite helpful for the organization to make better decision that whether the proposal must be accepted or not. In this technique, 2 or more projects are evaluated to make a better result. The proposal with higher average rate of return must be accepted by the investors.

5. Profitability index:

More, profitability index is the technique which measures the profit investment ratio. Profitability index is and index which attempts to analyze the relationship among the benefits of the proposed project and cost and mainly, it is calculated to analyze the total profit of the company. It evaluates the total profitability index by dividing the present value of future cash flows by initial investment. In this technique, 2 or more projects are evaluated to make a better result. The proposal with higher profitability index must be accepted by the investors.

Thus the above techniques are few methods of sophisticated capital budgeting techniques. These techniques are quite helpful for the organizations to make a better decision about the performance of the company.

Through the further evaluation over the capital budgeting, it has been found that the capital budgeting methods are quite useful for an organization or the potential investors to make a better decision about the investment It assist the organization to choose the best method but though, all the methods of capital budgeting are somewhere associated with various critique. According to Brunzell, Liljeblom and Vaihekoski, (2013), it has been found that capital budgeting methods require cash flow estimation which is quite difficult to evaluate due to various uncertainties which are existed in the market, environment and the functions of the business (Jain, Singh and Yadav, 2013). Further, the capital budgeting methods do not deal with the uncertainties while evaluating the project and the flexibility of the management (Abor, 2017).

Capital budgeting techniques mostly take the concern of assumptions and reach over a conclusion on the basis of assumptions which might lead the organization towards the failure (Hayward et al, 2017). Further, the capital budgeting methods are mostly used for compare two or more investment options to analyze the best project. According to the Meyer and Kiymaz, (2015), it has been found that the capital budgeting methods ignore the value creating options. Further, it has been added by Götze, Northcott and Schuster, (2015) that sometimes an investment proposal appears an uneconomical options to choose on the basis of some financial and non financial information.

More, it has been found that capital budgeting methods are quite complicated and quite lengthy. Further, it is also complicated for the analyst to analyze the various investment options. Rossi (2014) has added into his study that capital budgeting methods offer the best project out of various projects and though it also offer some conflict results. These methods do not satisfy the principle of value Additivity that is quite unique virtue of net present value.

Further, it has been added by Chittenden and Derregia, (2015) that the result of the capital budgeting could be more complicated if the list of assumptions is quite bigger. It is quite complex for analyst to analyze the exact cash outflows and inflows of a project due to its dependability. Various marketing, economical factors make an impact over the position and the performance of the company. Further, Haka et al (1985) has added into his study that capital budgeting techniques could be used by an organization through the nature and the main aim of the organization. Further, it has been added that capital budgeting methods require cash flow estimation which is quite difficult to evaluate due to various uncertainties which are existed in the market, environment and the functions of the business. Thus this depicts that the few issues are also associated with the capital budgeting methods which express that the outcome of the capital budgeting technique is not at all reliable and it manipulates the decision of the potential investors.

Conclusion:

According to the above study over capital budgeting, it has been found that the Capital budgeting is an investment appraisal technique which is used by the organizations and the investors to analyze the various investment opportunities. This technique is used for evaluate the long term investment. Capital budgeting is the procedure in which an organization analyzes and measures the potential expenses and income of the project in a large manner. These investment, returns and expenditure include various projects such as investing in long term venture and building a new plant.

This study depicts that the capital budgeting methods are quite useful for an organization or the potential investors to make a better decision about the investment. It assists the organization to choose the best method. Though, few issues are also associated with the capital budgeting methods which express that the outcome of the capital budgeting technique is not at all reliable and it manipulates the decision of the potential investors. Though, the study depicts that the capital budgeting methods are quite useful for an organization or the potential investors to make a better decision about the investment. It assists the organization to choose the best method.

Introduction:

Efficient market hypothesis is a theory of investment which directly depicts that it is not possible for anyone to beat the market because the efficiency of stock market because the stock which is already existed in the market incorporate all the relevant information and reflect those in the market. According to efficient market hypothesis, stocks in the market always trade at their face value on the stock exchange which makes it quite impossible for the investors to wither buy the stock on undervalued price or sell out the stock on inflated price (Jain and Jain, 2013). As such, it must be impossible for the overall market to outperform through market timing or expert stock selection and there is only way through which it could possible obtains the higher return is by buying some riskier investments.

Although, efficient market hypothesis is disputed often and highly controversial, Believers agree that it is pointless for an investor and the financial analyst to search for the undervalued stock or to analyse to predict trends in the marketplace through either technical analysis or fundamental analysis. But through according to the study, it has been found that Warren buffet have beaten the market consistently over a long period of time which is not possible according to the definition of efficienct market hypothesis.

Recent trends:

According to the given statement in the question, various changes have taken place in the process and the methods of the efficient market hypothesis. From 1970s to current times, a huge concentration on the sophistication and progressive development of theory of efficient market hypothesis has taken place. EMH is quite crucial for an analysts and investors to maintain and analyze the investment opportunity and buy and sell the stock accordingly  (Jamwal and Malhotra, 2016). However, various investors and the analyst still approach the EMH methods as an ad hoc fashion. Believers agree that it is pointless for an investor and the financial analyst to search for the undervalued stock or to analyse to predict trends in the marketplace through either technical analysis or fundamental analysis (Kim et al, 2015).

According to the current trends, the EMH theories are used by the stock market trends most rather than the investors and the financial analyst. The people believe that the theory of EMH is not at all relevant as the market could be changed by the investors as well which is done by the Warren buffet as well. It has been found that Warren buffet have beaten the market consistently over a long period of time which is not possible according to the definition of efficient market hypothesis.

The current trends of this study expresses that it is easier for the people and the investors to make the changes into the stock price of an organization at the same time, it also expresses that the new information about the stock and changes in the market also make an impact over the price of the already existed stock. Further, the current trends also express that the big financial analyst companies could rule over the stock market and make the changes according to their wish.

Further, it has also been found in current trends that the stock exchange keep a track over the stocks and analyze that whether the security s undervalued or overvalued and take a new step accordingly (Jain and Jain, 2013). In an economy where data could be driven very easily, collecting the good information is crucial. Especially, according to the efficient market hypothesis, it becomes very important for the investors and the analyst. According to the Amos et al, (2015), it is the best way for an analyst to not to try to wait for the time when the stock would be undervalued to buy the stock or the time when the stock overvalued to sell out the stock.  

Market efficiency:

Efficient market theory is quite complex and in current scenario everybody is not agreed with the concept of efficient market hypothesis. Few people agreed with the theory of efficient market hypothesis whereas few people depict that the market could be changed and it is not in the hand of the market that what would be the worth of the stock (Erdem, 2017). The new information also makes an impact over the position and the performance of the company. Further, efficient market hypothesis is disputed often and highly controversial, it has been found that Warren buffet have beaten the market consistently over a long period of time which is not possible according to the definition of efficient market hypothesis (Bodie, Kane and Marcus, 2014). But through according to the study, Believers agree that it is pointless for an investor and the financial analyst to search for the undervalued stock or to analyse to predict trends in the marketplace through either technical analysis or fundamental analysis (Marwala and Hurwitz, 2017).

Further, the current trends depicts that it is easier for the people and the investors to make the changes into the stock price of an organization at the same time, it also expresses that the new information about the stock and changes in the market also make an impact over the price of the already existed stock (Narayan et al,  2015). Thus, through this evaluation, it could be said that the market efficiency could be testable. Further, Khan and Khan (2016) has depicted into his study that the stock exchange are far more efficient and very less predictable than few recent academic paper.

Investor’s return:

Further, the study over efficient market hypothesis expresses that it is not easier for the investors to analyze the market and make the changes into the stock price according to their wish. But the current trends of the efficient market hypothesis depict that the current and new information are also considered by the market and it also make an impact over the position of the company (Komariah, Mahbub and Sin, 2015). Through the further evaluation, it has also been found that stock exchange sets a limit and tries that the price of the stock does not get fall much. Though, the current case of Warren buffet express that excess return has been get by Warren Buffet through analyzing the market and buy the stock when the price was undervalued and further by selling the stock once the price of the stock get overvalued.

Further, it has also been found that various other factors are also available in the market which consistently makes an impact over the price and the value of the stock of an organization and entire stocks in the stock exchange as well. If an investor analyzes the market perfectly than it becomes easier for the investors to get higher return (Bodie, Kane and Marcus, 2014). All is required for a financial analyst to be proactive and analyze the market perfectly to earn more return from the market. Though, few internal contacts are also required for the financial analyst to analyze the market and make higher return from the market.

Further, it has been found that various people used to believe that it is impossible for the investors to wither buy the stock on undervalued price or sell out the stock on inflated price (Narayan et al, 2015). Efficient market hypothesis is a theory of investment which directly depicts that it is not possible for anyone to beat the market because the efficiency of stock market because the stock which is already existed in the market incorporate all the relevant information and reflect those in the market (Hamid et al, 2017). Even the founder of the efficient market hypothesis which is E. Fama has found in one of his study in 1990 that various stocks in the market does not follow the random walk model and the performance and the value of these stocks are overvalued (Marwala and Hurwitz, 2017). According to a study, ‘momentum stock’ has been found where the stock of an organization has done very well in past and often continue to do the same in the future (Hayward et al, 2017).

Further, it has been added by Jain and Jain (2013) that if efficient market hypothesis theory is true than it is irrational for the organizations to spend money on research which is clearly done by the organizations. Further, various other factors are always available in the market which make an impact over the price and the position of the stock in the market (Erdem, 2017). Though, the current case of Warren buffet express that the efficient market hypothesis theory is not at all true and the stock could be controlled by the financial analyst and the investor with depth knowledge about the market and with relevant information about the stock and the market (Amos et al, 2015).

Conclusion:

To conclude, efficient market hypothesis is a theory of investment which directly depicts that it is not possible for anyone to beat the market because the efficiency of stock market because the stock which is already existed in the market incorporate all the relevant information and reflect those in the market. Further, through this evaluation, it could be said that the market efficiency could be testable as various factors are also available in the market which consistently makes an impact over the price and the value of the stock of an organization and entire stocks in the stock exchange as well.

Further, it has been found that various changes have taken place in the process and the methods of the efficient market hypothesis. According to the current trends, the EMH theories are used by the stock market trends most rather than the investors and the financial analyst. The people believe that the theory of EMH is not at all relevant as the market could be changed by the investors as well which is done by the Warren buffet as well. Further, it has also been found that if an investor analyzes the market perfectly than it becomes easier for the investors to get higher return.

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