Using of Capital Budgeting Technique in Company
Firms make various investment decisions with the aim of increasing profitability. These decisions are usually made after the company has evaluated and selected alternative investment opportunities that are available to them. After evaluating the alternative the company should be in a position to finance project or the investment. Some of the common investments made by companies include maintenance of existing capital such as machine replacement, increasing companies’ capacity, introducing a new product or service to the market and decisions relating to corporate social responsibility (Jae and Shim, 2008).
When making such decisions organizations are always faced with the problem of using the right capital budgeting technique, a proper method of a forecasting cash flow for the project. The strategy underlying some capital investment decisions is leadership in technology. Many companies have invested in computer-integrated manufacturing technology to improve quality, shorten lead times, and increase flexibility (O’Connell, 1999).
Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate. Some strategic investments are made to avoid putting a company at a competitive disadvantage. The benefit of capital investments in this case is not higher revenues but the prevention of a decline in revenues and profits. Such benefits may be difficult to quantify.
Consider some of the difficulties of justifying investments in technology. To quantify the benefit of efficiently manufacturing many different products in response to changes in consumer preferences requires some notion of consumer-demand changes that may occur many years in the future. Another benefit of investing in technology is that is increases worker knowledge of and experience with technology. The benefit of this knowledge and experience is difficult to measure.
Capital Budgeting Technique Used
Various methods are available for evaluating capital budget some of the method that are available include discounted and non discounted methods. Discounted methods include net present value, internal rate of return, profitability index, equivalent annuity, simulation and sensitivity analysis. Non discounted methods that are available for evaluation of project include payback period and accounting rate of return (Jae and Shim, 2008).
Net present value method uses discounted cash flow and a predetermined require rate of return or weighted average cost of capital to evaluate the project. A project is accepted if it has a positive net present value. Any project with a negative net present value is rejected while a project with zero net present value is indifferent. The net present value is calculated using the following formula:
Where k is requires rate of return. If the sum of these discounted cash flows is zero or more, the proposal is accepted; if not, it is rejected. The rationale behind the acceptance criterion is the same as that behind the internal-rate-of-return method. Most projects which have zero value of net present value are always considered viable if the company is financing its activities internally. When the company evaluate a project and find that it has a present value of zero they opt to take sensitivity analysis in order to se the impact of changes in variables. (Jae and Shim, 2008).
Internal rate of return is a rate at which the net present value is zero. This method is usually used to evaluate project which are not mutually explosive. The internal rate of return or yield for an investment is the discount rate that equates the present value of the expected cash flows with the present value of the expected inflows. It is represented by that rare, r, such that
Where At is the cash flow for period t, whether it is a net cash outflow or inflow, n is the last period in which a cash flow is expected, and Σ denotes the sum of discounted cash flows at the end of periods 0 though n. If the initial cash outlay or cost occurs at time 0, can be expressed as
A0 = +
Thus r is the rate that discounts the stream of future cash flows to equal the initial outlay at time 0 –A0.We implicitly assumes that the cash inflows received from the investment are reinvested to realize the same rate of return as r.
Profitability index compares the present value and initial investment. If the profitability is more than one then the project is profitable. The formula for the profitability index is shown below.
Present value / Initial investment
Pay back period is a non-discounting method of evaluating a project. It is the period of time taken by the project to recoup the investment. Payback period method has a weakness of not recognizing the time value of money and it is calculated as shown below for uniform cash flows.
Initial investment / Uniform increase in annual future cash flows
A project is accepted when the payback period exceed the predetermined payback period.
Another common method is accounting rate of return where it is increase in expected annual after tax operating income dived by initial investment. This method is actuary used by very few organizations. The formula for the method is
Accrual accounting Rate of return = Increase in expected average annual after-tax operating income / net initial investment
Result and Discussion
In this case we have used the net present value and internal rate of returns to evaluate these options. Excel spreadsheet as show in the appendix has been used to calculate the net present value of the project. Various assumptions have been made in calculating the cash flow of these options. Some of the assumptions made include that initial investments in working capital will be included in the salvage value shown in the table provided.
From the excel calculations option A and B should be rejected because both of them have a negative net present value and internal rate of return below the firms cost of capital. Spreadsheet has in-build formulas which I have used to estimate the net present value and internal rate of return. Option A has given me a negative net present value of $73,705 while option B has given me a negative net present value of $90948. This means the project intotoallity is not accepted under option A or B. The internal rate of return estimated using excel is 8% for option A and 7% for option B. These rates are lower than a cost of capital of the company therefore these options cannot be accepted as they will affect the long run profitability of the company.
Various factors are taken in to consideration when carrying out an investment. An investment like this one the effect on the environment is an important factor to consider. If the project has a bad impact of the environment in future the government may ban the project or introduce stringed measures which will affect the project profitability on the long run(Jae and Shim, 2008).
The entry of a competitor into the business may deplete resources making a recovery of the invested capital difficult. In investment will involve the use of equipment whose technology may change and the manufacturer cease to produce spare parts therefore rendering the equipment and the project very expensive. There should be also a consideration of the market for the product especially the demand to determine whether it will continue on that position (Eugene and Brigham, 2010).
In response to concerns of environment the government has made laws to restrict companies’ impacts on the environment. Many companies have viewed these laws as imposing costs on them, but attitudes are changing. Companies are increasingly shifting their focus away from pollution control (O’Connell, 1999).
The a company invests in new manufacturing equipment that allow it to use a less costly and non-toxic direct material. Annual cost savings directly associated with the use of the new equipment include savings in direct material costs and toxic waste disposal. If the capital budgeting analysis ended at this point, however, the investment might show a negative NPV, and the company would, on purely financial grounds, reject the project (Jae and Shim, 2008).
Another form of cost savings is the reduction or elimination of various fines or penalties that a company might experience because of non-compliance or accidents. Estimating these costs is more difficult and is generally based on statistical analysis of historical data for the particular company or industry, probability calculations, and professionals’ judgement.
Conclusion and Recommendation
From the analysis above using internal rate of return and net present value, the project should not be accepted in either option A or B. this is because it provides negative returns in both cases. The project assumptions have held in adjusting cash flows for the company. Acceptance of this project will lead to lost opportunity cost and negative results will lead to lost capital. Qualitative factors play an important job in selecting this project because of the impact of the environment.
List of References
Eugene, F., & Brigham, M., 2010. Financial Management: Theory & Practice. New delhi: South-Western College Pub.
Jae, K., & Shim, J., 2008. Financial Management.London: Barron’s Educational Series.
O’Connell, F., 1999, How to Run Successful High-Tech Project-Based Organizations. London: Artech House.