Capital Budgeting

Week 4 Discussion Question 1b

Introduction

Capital budgeting is one of the most crucial decisions the financial manager of any firm is faced with...Over the years the need for relevant information has inspired several studies that can assist firms to make better decisions. These models are assigned so that they make the best allocation of resources. Early research shows that methods such as payback model was more widely used which is basically just determining the length of time required for the firm to recover the outlay of cash and the return the project will generate. Other models just basically employed the concept of the time value of money. We have seen that more current models are attempting to include their analysis factors that might significantly affect the decision made by the manager (Cooper et.al, 2001).

Recent studies have shown that capital budgeting decisions are highly important and most times complex. There are several reasons associated with the use of capital budgeting. First, capital expenditures require the firms to outlay large sums of funds to initialize the project... Second, firms need to formulate ways that will generate and repay these funds that were initially outlayed. Finally, having a good sense of timing , when using this model is also very critical when making financial decisions. Several alternatives models are commonly used when evaluating capital budgeting projects (Brealey, 1984):

1. The payback method

2. Accounting Rate of Return

3. Present Value

4. IRR (Internal Rate of Return)

5. MIRR (Modified Internal Rate of Return)

6. Real Options

Academics criticize both the payback and accounting rate of return models because they tend to ignore the actual size of the investment and how it was calculated by using the Time Value of Money (Cooper et al, 2001). Unlike the NPV model when this is used the firm discounts the projected income from the project at the hurdle rate. This rate is an acceptable rate of return by the firm. We can arrive at the NPV by finding the difference between the present value of the income and the cost of the project (Cooper et.al, 2001). The rule is if the NPV is greater than zero or positive then the investment would add value to the firm. Conversely, if it is less than zero or negative than the investment would take away from the firm and as such the project should be rejected.

In reference to the statement made that the, "the general consensus appears to suggest that at the end of the day, the Net Present Value (NPV) method is superior to other methods of capital budgeting is conflicting and I can only partially agree with this statement. There was a study conducted by Mao (1970) that saw the Net Present Value (NPV) method of capital budgeting as the least popular. In one study there was an example of a questionnaire was sent out to a few companies that uses capital budgeting that engage in budgeting, mining, transportation, land development, retailing and utilities (Cooper et al, 2001). The particular study investigated different stages in capital budgeting processes and the ways or methods they used to adjust risk. The research further concluded that firms considered the IRR rate of return model as the most important models used for decision making. What most firms were doing was increasing their profitability requirement to adjust risk and considered defining a project and determining cash flow projects as most important and difficult stage of the process (Kim et.al, 1981). The IRR method or discounting cash flow projects as most important preferred for evaluating all projects. As it relates to risk, the most firms are still using payback method as a backup.

Others will agree that the NPV is the most superior because it presents the expected change in the shareholder wealth given a set of projected cash flows and discount rate. Another point is that when cash flows come in over a longer period of time, net present value will assume the intermediate term cash flows are reinvested at capital cost (Brealey, 1984). Most importantly, net present value is not sensitive to multiple changes in Cash Flow which is one reason why firms that have larger capital budget tends to favor IRR and NPV.

Practical problems associated with the Cash Flow estimations

Several decision makers have criticized the cash flow estimations as they simply do not agree with the decisions they have arrived at from the use of the models. Since there are uncertainties involved in terms of estimates of cash flows some managers become reluctant to use this method as a part of their decision making process as the calculations are far in the future. Therefore, they will take into consideration the near term cash flows. Other managers may have predetermined notions about which project to adopt and may therefore play with the numbers to achieve a desired result (Brealey, 1984). This can be a problem as the results they receive are not from faulty models but from the manager's inappropriate inputs into the models. Another area of concern is the selection or choice of discount rate (Cooper et.al, 2001). For example if they use an inappropriately high discount rate then this could

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