Capital Budgeting Techniques Analysisâ€Free Samples for Students

Question: Capital Budgeting Techniques Analysis? Answer: Introduction Capital Budgeting is a process in which the long term investments are evaluated in order to measure their feasibility and profitability. Some of such expenditures include addition or replacement of fixed assets, expansion of production, purchase of land and building etc. also a company may have to choose from a list of options as the amount to be invested is limited, in such cases, capital budgeting helps in the decision making. There are various techniques which are used in the process of capital budgeting. One of the most important techniques is Net present value (NPV). If the NPV of the project gives adverse results, the project is not accepted under any condition. Other techniques also play an important role. Capital Budgeting Analysis In the present scenario, Cussons Limited wants to choose between two capital investments. The capital budgeting techniques have been used to evaluate both the options. The results of the techniques are discussed below. Table of cash flows Project 1 Project 2 Project 1 Project 2 Year Cash flows Cost of capital Present value of cash flows 0 -2,50,000 -2,50,000 1 -2,50,000.0 -2,50,000.0 1 70,000 70,000 0.909 63,636.4 63,636.4 2 70,000 70,000 0.826 57,851.2 57,851.2 3 1,20,000 70,000 0.751 90,157.8 52,592.0 4 1,30,000 90,000 0.683 88,791.7 61,471.2 5 1,20,000 0.621 0.0 74,510.6 Project 1 Project 2 NPV 50,437.1 60,061.4 IRR 17.9% 18.2% (Calculations shown in annexure) Payback period Project 1 Project 2 Project 1 Project 2 Year Cash flows Cumulative cash flows 0 -2,50,000 -2,50,000 -2,50,000 -2,50,000 1 70,000 70,000 -1,80,000 -1,80,000 2 70,000 70,000 -1,10,000 -1,10,000 3 1,20,000 70,000 10,000 -40,000 4 1,30,000 90,000 1,40,000 50,000 5 1,20,000 1,70,000 Payback period 2.9 years 3.4 years Profitability Index Project 1 Project 2 Sum of cash flows 3,00,437.1 3,10,061.4 Initial investment 2,50,000 2,50,000 PI 1.20 1.24 Accounting rate of return Project 1 Project 2 Accounting Income 3,90,000 4,20,000 Initial investment 2,50,000 2,50,000 Accounting rate of return 156% 168% Capital Budgeting Techniques The techniques used above are very useful, however all techniques have their respective strengths and weakness, some of which are discussed below: Net Present Value (NPV) It is the most common used technique of capital budgeting. The future cash flows are discounted using the cost of capital. The excess of present value of cash flows over the initial investment is the net present value. A positive NPV makes the project acceptable and vice versa. Strengths Time value of money is recognized All cash inflows and outflows are considered in calculations Gives the value added by the project to the company Considers risk in the project as the future cash flows are discounted using WACC (in most cases) Weakness It is difficult to understand and calculate Does not gives the results in percentage, however managers are more interested in knowing the percentage returns It is very difficult to ascertain the correct cost of capital, a slight mistake in calculating the cost of capital may hugely vary the project results While comparing projects of different amount of investments, NPV is not the satisfactory technique Payback period It is the time period required by the project to recover its initial investment. Projects with high earnings in the initial period have lower payback periods and vice versa. Lower the payback period, the better it is. Some companies may set a maximum payback period within which the original investment should be recovered. If the investment is recovered within the specified period, the project is accepted (Titman, Martin, Keown, Martin, 2015) Strengths Easy to understand and calculate It gives some measure of risk as shorter payback period may ensure guarantee against future losses The liquidity of the project can be determined as the emphasis of the technique is on short payback period Weakness Time value of money is not recognized Cash flows within the payback period are only taken into consideration. Further future cash flows are not considered Profitability of the investment cannot be determined It is difficult to set the maximum acceptable payback period The magnitude and timing of cash flows is not considered Internal rate of return It is therate at which the NPV is 0. For a project to become acceptable, the IRR should be more than the discount rate. IRR is the rate at which the funds invested can be reinvested. It is called IRR because the calculation of IRR solely depends on all cash inflows and outflows. Strengths Time value of money is recognized All cash inflows and outflows are considered in calculations Helpful in comparing two mutually exclusive projects Suitable for managers as they are more interested in rate of return Weakness IRR calculation is complicated IRR assumes that the cash inflows are reinvested at the IRR whereas under NPV, cash inflows are reinvested at discount rate. The second assumption is more realistic It may give negative results and thus may not be helpful in decision making Profitability Index PI is the ratio of sum of discounted cash inflows to the initial investment. A project is accepted if the PI is more than 1 and rejected if the PI is less than 1. Strengths Time value of money is recognized All cash inflows and outflows are considered in calculations Helpful in comparing two mutually exclusive projects by using the incremental benefit ratio Weakness Cannot be used to evaluate two projects having different useful life Two projects having huge difference in investments and cash flows can give the same PI Accounting rate of return It is the ratio of average accounting income after taxes to the average investment. Strengths Is can be calculated using the financial statements Easy to use and understand Gives rate of return, hence preferred by managers Weakness uses accounting profits instead of cash flows ignores time value of money the life of project is not considered Recommendation It is recommended that the company should go ahead with Project 2 as it has a higher NPV, IRR, accounting rate of return and PI. The project has a higher payback period but that cannot be considered as a selection criterion because both projects have different useful lives. Reference Titman, S., Martin, T., Keown, A., Martin, J., (2015), Financial Management: Principles and Applications, 7th Edition, Pearson Australia