Question

Discuss the capital budgeting model, including the process used, as well as the implications for the decision-making process. Describe the implications of a positive, negative, and zero NPV. In your opinion, which parties are most directly impacted by a corporation initiating a positive NPV project? Explain.

Compare this technique with at least three other analysis techniques. Consider the purpose, strengths, and limitations of each technique as well as strategies for capitalizing on each analysis.

Answer 1

The capital budgeting model involves evaluation of different investment proposals through various techniques (such as NPV and IRR). With the use of these techniques, the company may be able to select the best alternative (out of various available investment options) and take a decision with respect to making investment in the particular project. Projects with negative outcomes may be rejected before any costs are incurred or investments are made, thereby, saving the company a lot of money, time and effort. However, it is important for the company to consider qualitative factors in addition to quantitative results provided by capital budgeting techniques before accepting/rejecting any project.

NPV is the difference between the present value of cash inflows and cash outflows. It is considered as one of the best capital budgeting techniques for evaluating the worthiness of any project. A project with a positive or zero NPV (present value of cash inflows is greater than or equal to the present value of cash outflows) is generally considered acceptable. However, a project with a negative NPV is generally rejected. It is because the costs associated with such a project exceed the potential benefits expected from the project and it is likely to decrease the market value of the firm. The parties mostly affected with the acceptance of a positive NPV project would be the company and its shareholders. However, it is likely to affect all the parties associated with the corporation (such as its employees and lenders). It is because a positive NPV project is likely to add more value to the firm, consequently affecting its shareholders wealth. Further, execution of a project with positive NPV is likely to boost the morale of employees and provide more confidence to the investors and lenders.

The other frequently used capital budgeting techniques include IRR (Internal Rate of Return), Payback Period and Discounted Payback Period. The purpose of calculating IRR is determine the minimum acceptable rate of return at which NPV would be 0. If a project provides IRR which is less than the cost of capital/hurdle rate, it is generally rejected. The purpose of calculating payback/discounted payback period is to determine the timeframe within which the initial investment is recovered by the company with the use of annual cash flows/annual discounted cash flows.

While IRR method is simple and easy to calculate/interpret and takes into account time value of money, it has its own limitations as it doesn't measure a project's suitability in absolute dollar terms. Further, it can provide multiple rates of return if the project has a mix of positive and negative cash outflows occuring at different points of time during the life of the project. Additionally, it assumes that all the cash inflows get reinvested at IRR which may not be practically possible, because in the actual scenario, an investment can be rarely made at the same rate. Generally a project with IRR greater than the cost of capital is accepted. An investment proposal with a negative IRR is rejected.

Payback period is very simple to calculate. However, it is not a reliable method as it ignores the time value of money. Further, it completely ignores the cash flows that may be provided by the project after the recovery of the investment made by the company. A project with a payback period less than its estimated life is generally accepted. However, a project whose recovery period is higher than the estimated life gets rejected with the use of this evaluation technique.

Just like payback period, discounted payback period is easy to calculate and interpret. One advantage (over the normal payback period) that this method additionally offers is that it takes in account the time value of money (as it uses discounted cash flows in the calculation). However, it suffers from the same limitation of ignoring cash flows occurring after the recovery of investment. As with the normal payback period, a project whose recovery period is higher than the estimated life gets rejected with the use of discounted payback period technique.

While each method has its own advantages and disadvantages, it is advisable for any company to use capital budgeting techniques in conjunction with each other while taking an investment decision.