Executive summary
This essay critically looks into the cons and the pros of various capital budgeting and project appraisal methods. The main techniques dealt with in the essay include payback methods, Discounted Payback Period, Net-Present-Value (NPV) Method, Internal Rate of Return (IRR), Modification of the Internal Rate of Return Method, and Profitability Index.
Amongst the techniques discussed in the essay, the paper finds that, the major techniques are Net-Present-Value (NPV) Method, Internal Rate of Return (IRR), and payback methods. The paper also finds that, although both NPV and IRR method yield better decision making foundation, even after being complicated capital budgeting techniques, the payback technique is not without a reason. Payback technique provides the quickest method of filtering projects to select these that time ought to be spent upon in other sophisticated methods, while eliminating these that spending time on them will just be a waste of time
Though NPV and IRR provides the best sophisticated criterion for elimination of unavailable methods, the two provides conflicting values based on the various reasons as discussed in the essay. The essay concludes that IRR method is preferred by many managers as compared to NPV. This is based on the reason that it portrays its results in terms of rates of return. At the same time, the essay recommends that, every company should employ the best method of capital budgeting and project appraisal method that suits its own conditions.
Introduction
Capital budgeting is the process by which the investors determine whether some projects like building new plants or even investing in a long term venture is profitable or viable. In this process, prospective project’s lifetime, cash flows, as well as outflows are all assessed. This will be much helpful in the determination of whether generated returns can be in a position of meeting sufficient target benchmarks. This essay critically analyses the pros and cons of commonly used measures in the decision making process, and comes to a conclusion based on the literature surveyed as to which of the methods is theoretically correct and most popular.
Payback Method
This is far much significant method due to its simplicity factor in its operations. Their calculations needs just taking expected cash inflow in every year after initial investment, and then add them to the point at which the business will pay back the initial investment or the breakeven point. To some extend, the method explains some information concerning the risks that the project is likely to face while under operation.
It has been found that, the payback method is just a one-sidedly derived number, which shows very little about the projects starting points, but ends up explaining nothing about the entire lifetime of the project. The lack of effort in payback calculation can in one way or the other promote carelessness. This is particularly in the failure of incorporating all expenses connected with the process of investing into the project, like training of staff members and equipment maintenance. The method does not also explain anything about the time value of money. As a result, it has been considered as being unsophisticated capital budgeting method. Though there are cons associated with payback method, its simplicity can allow it to be used as a project filter. It can be used to select which project can move to amore detailed technique. If based on payback the project does not qualify; there is no need of considering other methods.
Net-Present-Value (NPV) Method
This method considers time value of money, hence referred to as sophisticated capital budgeting method. In this method, everything is calculated based on the current dollar. In addition, the method is easier to calculate manually as compared to internal rate of return (IRR) method. Nevertheless, the technique provides a more realistic solution as it takes into account the projects “reinvests intermediate cash flows at the company’s cost of capital rate, rather than the high rate specified by the IRR method” (Arthur, & Sheffrin, 2007). It has been depicted that, the method considers all cash flows as well as inflows during its calculation, hence can tell whether the investment will tent to increase the proposed project value. Last but not least, the method considers all the risks of future cash flows by the use of cost of capital.
On the other hand, the method is considered as being much insightful. This has been based on the fact that, it does not take into consideration the issues of interest rates , profitability as well as other benefits that tent to be relative to the invested sum. This depicts that, NPV method just provide only one measure of the expected sum of money accrued from the proposed project. In most cases, financial managers and analysts desire seeing results measured in terms of annual rate of return, such as IRR. The method is too sophisticated as it requires the estimation of the cost of capital for the calculation of net present value. It does not express the value in terms of percentage, other than presenting in terms of dollars, (Hit, 2009).
Internal Rate of Return (IRR)
This is another sophisticated method of capital budgeting technique. This is one of the most utilized methods in the entire world. However, the method is too complicated when calculated manually, or even spreadsheet application whose usage might be required. Business people basically would prefer seeing calculation results inform of annual rates in place of seeing them in terms of actual dollar returns. This is based on the fact that, the earlier provides them with more room of comparing even two or more projects for ranking reasons, and look at the project that is going to provide them with a more bang for the buck.
The use of IRR method, gives the results of the rate of return, which is particularly significant in the current economic environments; “where businesses are trying to cut costs and only invest in those projects which will yield a higher rate of return” (Arthur, & Sheffrin, 2007). It has been considered that, IRR technique tells more about whether the investment will tent to increase the company’s value or not. This is achieved based on cash flows and inflows on top of interest rates; that the method takes into consideration. Just like NPV, the technique considers time value of money by taking into Consideration Company’s life time and the interest rates. Analysts have confirmed that, the method takes into consideration the risks of future cash flows based on the cost of capital placed in the decision rule.
On the other hand, as stated earlier, the method is far much complicated and difficult during manual calculation. As a result, it ends up consuming lots of time and resources. Though it is the preferred method for capital budgeting due to its intuitive appeal, it lots of complications, which might arise during its usage. This is so particularly in the presence of non-conventional cash flow patterns. Apart from these mentioned above, the method require estimation of the cost of capital for the managers to make decisions based on IRR method. Though it provides a basis for the decision making, the technique does not in any way provide value maximization decision, when applied in the comparison of mutually exclusive project proposals. In the presence of capital rationing, the process also is incapable of providing value maximization decisions. Though liked by many managers, this technique is not applicable in particular conditions under which, signs of cash flow of a project changes more than once during the project’s lifetime, (Ross, et al, 2009d), and (Ross, et al, 2005b). .
Modification of the Internal Rate of Return Method
This is one of the most used capital budgeting technique. The technique has been implemented with the aim of carrying out those calculations that have not been taken care of in the IRR technique. It has been found out that, the method overcomes the tendency of over-estimating returns by using current company costs of capital, as well as rates of return on the reinvested cash flows. The technique also explains more on whether the investment will increase the firm’s value. This is obtained after considering interest rates, as well as cash flows of the proposed project. Since the method considers time frame and interest rates, it has the capability of considering time value of money. Due to the fact that the method considers the costs of capital placed in the decision rule, the technique has the capability of considering the riskiness of future cash flows, (Scott, 2008).
On the other hand, for the method to be used in decision making process there is need for the estimation of capital costs. Just as depicted in the Internal Rate of Return, the method does not in any way provide value maximization decision when applied in the comparison with mutually exclusive project proposals. In the presence of capital rationing, the technique also becomes incapable of providing value maximization decisions. Though liked by many managers, this technique is also not applicable in particular conditions under which, signs of cash flow of a project changes more than once during the project’s lifetime, (International Good Practice, 2008), (Gitman, 2009a) and (Gitman, 2009b).
Profitability Index
This is also known as the benefit cost ratio, which is another significant measure that uses simple rules of thumb for the evaluation of proposed projects. In this case, this method informs managers that, certain projects ought to be accepted as there profitability index is either equal to or greater than 1. The technique provides mangers with similar results as provided by NPV.
Just like NPV, the method considers all cash flows as well as inflows during its calculation, hence, has the capability of predicting whether the investment will tent to increase proposed project value. Last but not least, the method considers all the risks of future cash flows, by the use of cost of capital.
On the other hand, the method is time consuming as it needs the estimation of capital cost, which is applicable in the calculation of profitability index. In addition, the technique might not provide the most reliable decision making foundation when applied in the comparison of mutually exclusive projects.
Discounted Payback Period
This is just an improvement of payback method as explained earlier on. However, it differs from payback method in the sense that, the method considers time value of money. It also takes into account the consideration of riskiness of the project’s cash flows, by the help of the cost capital. On the other hand, the method does not provide reliable decision making criterion, that shows if the investment made increases the company’s value or not. In addition, the technique is time consuming as it requires the estimation of capital cost, which is much essential in the payback calculations. Another problem with this technique is that, it does not take into consideration the cash flows beyond the discounted payback period.
Conclusion
After analyzing different capital budgeting techniques, it can be realized that, there are only three major techniques, namely; NPV, IRR and Payback. The other methods are just modifications of either one of the three methods. When looking for payback period, the projects which reach their break even point earlier than the others are the ones picked to move to high project approval methods. When NPV technique is the one under application, the basis for project selection depends on whether the value is greater than, equal to or less than $0. However, it is estimated that, the project with the highest NPV value, is the one recommended as being viable. Last but not least, are the selection criteria for IRR? The procedures of deciding to either accept or reject a project, is based on whether registered “IRR is greater than the cost capital, and then the final recommendation would be to move forward with the project” (Glann, 2009).
Although both NPV and IRR method yield better decision making foundations, even after being complicated capital budgeting techniques, the payback technique is not without a reason. Payback technique provides the quickest method of filtering projects to select these that time ought to be spent upon, in other sophisticated methods, while eliminating these that spending time on them is just like wastage of time. Though NPV and IRR provide the best rejection or accepting results, the two methods produces conflicting values. This is based on the scaling problems.
It has been proved that, the Western Europe expansion is approximately much higher as compared to that of Southeast U.S projects. Secondly the South East has the highest rate of return, the opportunity of making much larger, while Western Europe investment is much more attractive. Another point is that, a higher NPV value is generated by proposals of product developments, while marketing campaign proposals of a similar product offers a higher IRR. This conflict also arises due to differences in the differed timing of two projects’ cash flows. As an effect, an NPV for the development of products exceeds NPV for the marketing campaign (Apollo Group, Inc, 2008), (Ross, et al, 2009a) and (Ross, et al, 2009c).
As a result, comparing the two, the advantage of NPV is that, it directly measures the contribution of the dollar to stakeholder’s wealth, while IRR shows the returns on the original capital invested. On the other hand, the disadvantage of NPV method is that, it does not measure product size, while IRR gives conflicting answers for mutually exclusive projects. A multi IRR problem can also be of a greater issue. However, IRR technique emerges to be the most preferred technique. This is based on the reason that, it portrays its results in terms of rates of return, which is preferred by most managers.
Recommendations
It is true that, organizations and companies have many projects that are worth implementing, but, there might be finically problems. Due to these financial problems, companies should select the alternative that has been ranked the best by the capital budgeting methods. Such projects should be implemented till the end of Budgeted capital. Since most managers prefer IRR technique, it should not be automatic that all firms follow IRR technique. There are other methods that different companies might chose from, provided that it fits the company in under applied conditions.
