Finance and accounting
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Address the following issues/questions:
Many businesses around the world still fail because their capital investment decisions are based upon a calculation on the back of an envelope and do not take any of the correct factors into account. Even larger businesses often get this wrong. This is a true sign of poor resource management.
Do you agree or disagree? Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments. How do you think that capital budgeting decisions should ideally be made by different types of organisations?
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SAMPLE ANSWER
Finance and accounting
Concept Exercise Week 6 PART B
I am in agreement with the statement. Many companies fail given that their capital investment decisions do not consider the appropriate factors. This is an indication of poor resource management. Capital investment decision basically mixes several aspects of finance and accounting. Many business factors mix to make business investment arguably the most significant fiscal management decision. Capital investment decisions are made to allocate the capital funds of the company most effectively to ensure the best return possible (Goodman et al. 2014). The most vital facets of capital investment decisions are assessing the projects and allocating capital depending on the project’s requirements. It is therefore of major importance to take correct factors into consideration when making capital investment decisions.
Alternative methods of investment appraisal: Internal Rate of Return – the IRR of a project is understood as the cost of capital or the discount rate which makes the project’s NPV zero. In essence, the IRR could be found through trial and error; the net present value is calculated at dissimilar discount rates until a discount rate is found which makes the net present value zero, or adequately close to zero (Kida, Moreno & Smith 2010). IRR limitations: firstly, does not consider the cost of capital and therefore should not be employed to compare projects of dissimilar length. Moreover, as an investment tool, the IRR must not be utilized in rating projects that are mutually exclusive. It should only be utilized in deciding whether or not one particular project is worth investing in (Kida, Moreno & Smith 2010). When it is compared to the NPV, the IRR method could sometimes give answers that are contradictory.
Net Present Value: a project’s NPV represents the absolute increase in shareholder wealth that is created by a given project. This investment appraisal technique supposes that every cash flow produced by a given investment would be reinvested at the organization’s cost of capital. Gupta and Banga (2009) noted that this is realistic given that the firm’s cost of capital actually matches up to the rates available in the marketplace, or the return which could be attained by investing in other projects. Limitations: the limitation of this investment appraisal technique is that it does not measure the size of the project. In addition, the NPV is based upon future cash flows as well as discount rate, both of which cannot be estimated with absolute 100% accurateness. In addition, there is always an opportunity cost to making an investment but the calculation of NPV does not consider this.
Payback period method: payback period is understood as the amount of time that it would take for the cash flows that are generated by a given project to pay back the original cash outflows – for initial costs, working capital, and capital investment – at the beginning of the project. This technique is based upon cash flows and not profits and disregards non-cash items like depreciation. Limitations: it overlooks the time value of money; it does not consider cash flows which are beyond the periods of payback thereby overlooking a project’s profitability (Farrant et al., 2009).
Ideally, capital budgeting decisions should be made to increase the value of the company by taking on a good project at the ideal time. In making the decision, the manager or owner should ensure that the company’s limited resources are allocated to the project that would best attain the company’s strategic goals. Capital budgeting decision should seek to maximize shareholder’s wealth by getting assets and generating profit.
References
Farrant, K, Inkinen, M, Rutkowska, M, & Theodoridis, K 2013, ‘What can company data tell us about financing and investment decisions?’, Bank Of England Quarterly Bulletin, 53, 4, pp. 361-370, Business Source Complete, EBSCOhost, viewed 2 July 2015.
Goodman, T, Neamtiu, M, Shroff, N, & White, H 2014, ‘Management Forecast Quality and Capital Investment Decisions’, Accounting Review, 89, 1, pp. 331-365, Business Source Complete, EBSCOhost, viewed 2 July 2015.
Gupta, A, & Banga, C 2009, ‘Capital Expenditure Decisions and the Market Value of the Firm’, IUP Journal Of Applied Finance, 15, 12, pp. 5-17, Business Source Complete, EBSCOhost, viewed 2 July 2015.
Kida, T, Moreno, K, & Smith, J 2010, ‘The Influence of Affect on Managers’ Capital-Budgeting Decisions’, Contemporary Accounting Research, 18, 3, pp. 477-494, Business Source Complete, EBSCOhost, viewed 2 July 2015.
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