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The capital budgeting decision has been a very typical issue in the sustenance of a company. Several companies have lost their identity or liquidated due to wrong capital budgeting decision they made at a particular point of time. Based on these common problems in industries and the effect of globalization on industries, it is important to use effective method before making any investment decision.
Capital budgeting is extremely important because the decision made directly affects the organization future growth.Importance of Capital budgeting to organization:
- Effective capital budgeting helps to improve the timing of asset acquisition and the quality of assets purchased
- When asset acquisition is planned properly, the organization is able to acquire and install in a manner
- Generally all organizations tend to order capital goods at the same time when sales in a particular industry are increasing strongly.
Capital budgeting is a process in which a business determines whether projects such as building a new plant or investing in a long term venture are worth or not. Most of times, a prospective project's lifetime cash inflow and outflows are assessed in order to determine whether the return generated meet a sufficient target. Capital budgeting is also known as Investment Appraisal. Ideally, business should do all those projects and opportunities which enhance shareholders value. Generally, businesses prefer to study a project before taking it on, as it has a great impact on the company's financial performance. Capital budgeting is an important tool. One important duty of a financial manager is to choose investments with satisfactory cash inflows and rate of return. A financial manager should be able to decide if an investment is worth undertaking and should also have the ability to choose intelligently given other alternatives. Capital budgeting is primarily concerned with sizable investments in long term assets. These assets can either be tangible items such as property, plant & machinery or intangible ones such as new technology, patents or trademarks. Investments in processes such as research, design and development and testing- through which new products are created may also be viewed as investments in tangible assets. (Don Dayananda et al 2002)Why is the investment appraisal process so important?
Investment appraisal means to check out whether an investment or a project is acceptable, profitable for business or not. Investment appraisal is related with a long term projects which involves huge amount of funds of the company. Investment appraisal process is helps the management to take a very important decision about the future investment.
Company's main aim is increase the shareholder's fund. For this company has to invest in new projects, to judging investment appraisal process help the management or manager to take a rite decision. Investment appraisal process is very important for the company because before accepting any project firm has to analyse all available projects that which one is beneficial for the organisation, otherwise if the firm has take wrong decision which is going to making loos in firm and which decrease the shareholder's fund.
Many companies lost their identity or bankrupts because of the wrong investment decision. If the organisation takes rite decision that helps it to increase its wealth, market share, value, assets. Investment appraisal is a game in which manager has to take rite decision or manage cash inflows and cash out flows, so with help of it company get maximum return.What is the payback period of each project? If AP Ltd imposes a 3 year maximum payback period which of these projects should be accepted?
Here we have two projects A and B. The calculation of PBP of both project are as below. Company has decided to accept that project which has less payback period of 3 years.What are the criticisms of the payback period?
As par the rules of bad and good things of every thing in the world, as payback period also have some criticisms against his strengths are as given below,
- Pay back period method ignores timing of cash flows.
- This methods also ignore the time value of money also.
- It is not best method to select projects which has same payback period.
- Payback period method always support short term projects not longer projects, which is not always good that short term period always beneficial.
- This method takes account of the risk of the timing of cash flows but not the variability of those cash flows.
- It ignores any benefits that occur after the payback period i.e. it does not measure total income.
- It is difficult to distinguish between projects of different size when initial amounts are vastly divergent.
After doing the calculation of projects we find two NPV (1) £31740 and (2) £34200. Project B NPV is more than the NPV of the project A. Company should accept project B.Describe the logic behind the NPV approach.
Investment appraisal includes two methods for capital budgeting or long term decision making. These two methods are (1) Traditional method and (2) Discounted cash flow method. Net present value method is part of discounted cash flow method.
The Net present value is defined as the difference between the present value of the cost of inflows and the present value of cash out flows. NPV is very usable or acceptable method of capital appraisal. It considered the timing of the net cash flows, project's profitability and the return of the original investment. NPV is a technique where cash inflows expected in future years are discounted with its present value. Concept and the calculation of the NPV method is very easy to understand for any one. While computation of NPV, the cash flow occur at different level of time are adjusted with the time value of money using a discounted rate that is the minimum rate of return required to accept the project.
NPV method is used in capital budgeting to analyse the profitability of an investment and it is sensitive to the reliability of future cash flows that the investment will yield. For example: - NPV compares the value of pound today and that same pound in the future. Accept the project which have positive (+) NPV and reject the project which have negative (-) NPV.What would happen to the NPV if: (1) The cost of capital increased? (2) The cost of capital decreased?
- If the cost of capital increased?
- If the cost of capital decreased?
Cost of capital means rate of return, i.e. the cost of a financing in a project. If the cost of capital or rate of return increased the NPV is going decreased.
NPV started increased, if the cost of capital will decrease. There is vice versa affect on the NPV on increase or decrease of cost of capital.Determine the IRR for each project. Should they be accepted?
- Accounting for Non- Accounting Students, J.R. Dyson, 7th edition, FT Prentice Hall
- Quantities Methods For Business Decision, Curwin J. and slater R. , 6th edition, Thomson Learning