Pros And Cons Of Capital Budgeting Measures Finance Essay
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Published: Mon, 5 Dec 2016
Capital budgeting refers to the process in which a firm determines whether a project or investment is worth pursuing. More often than not, the process involves a long term assessment of the cash inflow and outflows to determine if the returns generated meet the investment appraisal. The most common methods used are the net present value (NPV) where evaluation of the project is based on the amount by which its value is maximized. Other measures or tools used in decision making include: the internal rate of return (IRR), a version of the IRR known as the modified internal rate of return (MIRR), the discounted payback period (DPB), a profitability index method (PI) and the traditional payback method. Regardless of the demerits presented by each, most firms or financial managers tend to stick to a certain method of capital budgeting. This discourse explores each of the measure as they apply to real world process of project approval. The discourse comprehensively reviews and evaluates the advantages and disadvantages of each of these measures with regards to their effectiveness, project size and long term/ future returns.
Based on review of recent literature in business related journals, the discussion primarily sought to determine which version of capital budgeting method is most suitable for big and small businesses. The findings of the discourse indicate that capital budgeting decision is a unique investment decision making tool to macro or micro enterprises and there is no one size fits all solution. As a matter of fact, certain methods of capital budgeting are identified with the level of project, size of firms and innovation levels. The discourse also established that while most chief executive officers or managers have distinct capital budgeting models, not all yield the same results for a company or even meet listed project or investment expectations.
Capital budgeting involves a series of identifying, evaluating and implementing long term investment opportunities in a firm or business venture. Depending on the measure or technique employed, firms seek to identify investments that will increase their shareholder wealth. The decisions involved largely target or aim at assessing a project that demand large upfront investment coupled with a series of small cash inflows. The most commonly used measures of capital budgeting are NPV, IRR, MIRR and DPB methods. Distinct as they are in approach, each presents its strengths and weaknesses when it pertains to project evaluation or capital budgeting.
Internal rate of return (IRR)
According to recent budgetary surveys, the internal rate of return has received more preference for project evaluation than other techniques (Rousse, 2008, p. 2). The IRR presents analysts with an avenue through which rates of return are quantified in an investment and according to Kelleher & MacCormack (2004, par. 4), managers opt to finance projects with high IRR based on their selection of the project value but at the same time destroy shareholder wealth in the investment. IRR can generate different values for the same project when future cash flows switch from negative to positive and back. More often than not, the IRR is expressed as a percentage thereby making small projects appear attractive and large ones great (Kelleher & MacCormack, 2004, par. 4). As evident in most IRR projects, the general rule dictates that where the measure is greater than the opportunity cost of capital, all investments remain acceptable.
Strengths and Weaknesses
As one of the most commonly employed measures in capital budgeting, the IRR draws its popularity from the fact that it is based on a discounted cash flow. When used effectively, the IRR method provides viable or feasible options on a project value. On the flip side however, internal rate of return has numerous risks that outweigh its merits. The method is essentially inconsistent and exposes shareholders’ wealth at risks minimizing their objective (Rousse, 2008, p. 1). The IRR may exhibit multiple rates of return when cash flows shift from negative to positive multiple times (Kierulff, 2008, p. 327). If managers and analysts are to continue using IRR, then major adjustments are to be made over the measure’s critical assumption: that interim cash flows will be reinvested at the same high rates as the returns (Kelleher & MacCormack, 2004, par. 5). Even more disturbing is the practice that practitioners frequently employ in interpreting the IRR; when computing the IRR, practitioners usually equate the measure with return on a given investment.
Net present value (NPV)
The net present value of a capital project or an investment is the aggregation of the present values of all benefits (in cash) by deducting the present value of all cash (Elumilade, Asaolu & Ologunde, 2006, p. 145). The NPV basically involves evaluation of the amount by which the value of a given project is maximized. As the name suggests, the basic premise for the net present value is the assumption that monetary value of a currency today is worth more than its future value. According to Rudolf (2008, p. 1), the logic behind the premise is that present cash can be invested and generate interest. Profitability is determined by evaluating the return on the invested capital whose net present value is zero. Negative NPV implies that the project is not desirable while a positive NPV means the project is viable. Theoretically, all estimations made in the NPV involve measuring the project’s future net cash flows such that they are discounted at appropriate cost of capital to procure their present value (Elumilade et al., 2006, p 145).
Strengths and Weaknesses
The net present value method is effective for both the assessment of new investments and comparison of investment alternatives (Rudolf, 2008, p. 2); the investment with the higher NPV becomes a more viable alternative. Based on its additive process, the net present values of different investments with different discount rates can be added up. A notable strength of the NPV is that it recognizes the risks associated with future monetary value using the money concept. Another strength of the NPV method is that it is an arithmetically simple procedure that when computed presents easy interpretation as the capital value is expressed in monetary units. In addition, the NPV offers managers with the possibility of adapting the discount rates for different periods (Rudolf, 2008, p. 2).
In line with the IRR, the net present value has several drawbacks much as it is popular in capital budgeting. For one thing, the NPV lacks visibility of a time frame on which a project is expected to generate positive values given the simplicity in calculations. While the NPV’s basic premise is to accept all investment greater than zero, the measure is however not clear of when the positive values are achieved. In cases where a new project has higher risks than a company’s cost of capital, its cash flow should be discounted at a higher rate to mirror that risk. But if they are, the reinvestment rate becomes detached from the cost of capital such that the investment rate for the new product introduction is way above the normal cost of capital (Kierulff, 2008, p. 323). Hypothetically, the NPV tends to generalize and assume that at any given time, the capital is always abundant and thereby no capital rationing. Supposing the resources are scarce, practitioners have to do some critical examination of not just the measure, but each and every available project and size of investment.
Modified internal rate of return
The modified internal rate of returns is a derivative of the IRR with the exclusion of the aforementioned drawbacks. Compared to the internal rate of return, it provides a more accurate percentage measure of financial attractiveness (Kierulff, 2008, p. 322). Based on existing literature, the MIRR method has not received much attention. Within a sample of 15 significant and highly respected finance textbooks, nearly all have ignored the MIRR (Kierulff, 2008, p. 322). Given the widespread use of NPV and IRR, financial institutions across the globe overlook the importance of the modified internal rate of return method.
The main idea behind MIRR is simple computation that may seem challenging in practice because of the need to estimate reinvestment rates (Kierulff, 2008, p. 326). The modified IRR involves three basic procedures that when utilized effectively present the best measure of capital budgeting. The first step involves discounting investment funds committed to the project back to present at a rate that fairly reflects the investment risk. Two, with the exclusion of investment, the free cash flow is compounded forward within a time frame and a chosen reinvestment rate. It is worth noting that the reinvestment rate represents projected future opportunities with risks equal to investment risk. The final step involves calculation of the internal rate of return.
Strengths and Weaknesses
There are several reasons why firms should ditch the traditional IRR and embrace the modified version. While the former exudes rigidity in changing the reinvestment rate and assessing impacts, the MIRR function permits both a finance and reinvestment rate to be associated with the stream of cash outflows and inflows in investment evaluation (Block & Bell, 2009, par. 14). Unlike the IRR or NPV, a company is able to tell whether an investment increases its value through MIRR. With MIRR, risks of future cash flows, time value of money and cash flows of the project are considered. Both NPV and IRR share significant drawbacks in that both of them have problems of size, timing and ranking. Moreover, NPV and IRR renders management locked into assumptions about how free cash flows will be reinvested by giving unrealistic view of investment’s actual potential (Kierulff, 2008, p. 328). Of the three, MIRR is the most effective considering its capability in dealing with the mentioned problems.
Like the other decision tools, the modified internal rate of return has its share of weaknesses in capital budgeting. Some of the techniques in MIRR require adjustments for effective functioning in practice. For instance, the method requires an estimate of the cost of capital for one to make a decision and when used to compare mutually exclusive projects, the measure may fail to produce value-maximizing choices.
Discounted payback method (DPB)
The discounted payback method simply measures the period it takes to recover the initial investment using discounted cash flows. In DPB, projects with the shortest payback periods are ranked highest or considered the most viable. Unlike NPV, IRR and MIRR, the criterion used in discounted payback method centers more on profitability rather than liquidity. This method has many advantages over other measures. The discounted payback period is simple to understand and easy to compute. Additionally, the method offers a more conservative measure of the relative liquidity of an investment than the traditional payback method (Bhandari, 2009, p. 3). The DPB function allows for a better gauge of the economic breakeven point and can be interpreted as a period beyond which a project generates economic profit (Bhandari, 2009, p 3). Even so, the method’s efficiency is reduced in cases where cash flows beyond it are overlooked. Another of its weakness is that it requires an estimate of the cost of capital for one to compute the payback and exudes a part whole bias in special cases such as assessing or valuing long term projects.
Profitability Index (PI)
Profitability index is also known as the cost-benefits ratio as it involves ratio of the present value of future cash benefits at the required rate of return to the initial cash outlay of an investment (Elumilade et al., 2006, p 146). The PI is another capital budgeting methods used by entrepreneurs in choosing among countless causes of action. The monetary cost of a project is ascertained and compared with its expected benefits in monetary term. The profitability index computes the present value of benefits to that of the cost such that when PI is greater than 1, the project is termed as acceptable.
By comparison, the PI method is a slight modification of the NPV only that this time, the PI evaluates project using a return element. Its close relation with the net present value may lead to identical decisions in project evaluation. The PI method is easier to understand and tends to communicate more easily than the NPV. For firms initiating smaller or larger projects, the PI acts as an effective tool regardless of the project size. On the flipside however, the values obtained in profitability index may not be as accurate as the ones in IRR.
The survival, growth and development of a firm is heavily dependent on constant flow of ideas for new products and ways to make existing ones better. Capital budgeting is one of the most important factors in the process of corporate decision-making. The whole process of capital budgeting calls for a series of stages in which the project is evaluated and feasible options employed. For a firm to make rational decisions, specific objectives must be included to maximize profits with one eye on the projected long term return (Elumilade et al., 2006, p. 141). Identifying and evaluating possible projects and alternatives makes the all essence of capital budgeting and this fundamentally implies that a firm has to find a measure that is uniquely in congruence with its short term or long term objectives. The existent body of literature, primarily those included in this discourse, identify NPV and IRR as the most popularly used by firms. Whether this is a testament of their superiority in practice is still debatable as each of them has its own drawbacks. It is difficult to find one measure that would work for every organizations.
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