Question

A corporate organization may incur a huge capital expenditure with the motive(s) of expanding operations and/or replacing a fixed asset. As a result of this, several appraisal techniques have been developed to help corporate organizations make the best investment decisions to increase the shareholders' wealth. However, among the various appraisal techniques the "Net Present Value (NPV) is considered as the king of capital budgeting." Critically examine this statement.

Please, need sample answers to write 2 and half pages of an eassy about it.

SUBJECT: MANAGERIAL FINANCE

Answer 1

A method of capital budgeting, to be really effective, should have the following attributes:

1. It should consider time value of money. This is at the root of CB analysis as one would be comparing cash inflows and outflows that occur at different points of time, which requires all cash flows to be taken [value wise] to a common point of time. Such a requirement can be done only by compounding or discounting the cash flows.

2. It should tell the amount by which the shareholders’ wealth will be increased in case a project is undertaken. This is so because, the goal of a firm and its financial management is 'maximizing shareholers'/owner's wealth.

3. It should be able to consider the risks attached to the cash flows of the project.

4. It should consider the entire stream of cash flows that occur during the lives of the evaluated projects.

5. It should be easy to calculate and understand.

6. It should be accept/reject projects and be able to rank mutually exclusive projects.

Evaluation of methods of Capital Budgeting:

The methods of capital budgeting can be divided into two:

· Traditional methods or non DCF methods, and

· DCF [discounted cash flow] methods.

Traditional methods:

1. Payback period:

It is the time taken for the cash flows from the project to recoup the initial investment.

It is calculated as: Initial investment/Annual cash inflow and is stated in number of years with fraction if required.

If the payback period is within the maximum prescribed period, the project is accepted; otherwise not.

The payback period is based on cash flows and it considers risk as it prefers shorter projects. Projects can also be ranked in the ascending order of payback period. The greatest advantage of the method is that it is easy to calculate and understand.

Its drawbacks are serious in that, it does not consider time value of money, it ignores cash flows after the payback period, does not give the net addition to shareholders’ wealth on undertaking the project.

To sum up, the drawbacks of the method outweigh the merits and hence, the method can be used only as an additional criterium, along with DCF methods.

2. Accounting rate of return:

Known by the acronym of ARR, it is calculated as: Average annual net operating profit/Investment. The average profit is taken from accounting records which are based on the accrual system. It is calculated as a percentage.

The rule for acceptance is that the ARR of the project should be more than the MARR set by the management. It can also rank projects in the descending order of ARR.

The advantages of the method are that, it is easy to understand and calculate.

The drawbacks of the method are too serious. The method, is not based on cash flows, ignores time value of money, ignores risk, does not give the addition to networth of shareholders, and so on. Hence, the method can be used only as an additional information.

DCF Methods:

1] IRR:

IRR is that discount rate which makes the NPV 0. It is found out by trial and error, by varying the discount rate to get 0 NPV. In other words, it gives the rate of return of the project by considering time value of money of the cash flows.

The rule for acceptance is: If the IRR of a project is greater than the cost of capital appropriate for the project, the project is accepted; otherwise it is rejected. Projects can also be ranked in the descending order of IRR.

The advantages of IRR are strong. It considers time value of money, it is based on cash flows, it can consider risk by adjusting the cost of capital and it is easy to understand.

In contrast the drawbacks are: One can get multiple IRRs in the case of non-conventional cash flows, it is difficult to calculate as it may require many iterations to arrive at the rate [though now a days, calculators make it easy], it assumes that intervening cash flows are reinvested at the IRR of the project-which assumption is unreal, because of the assumption of different reinvestment rates for different projects it ranking of projects may be in conflict with the NPV method in certain situations; it does not indicate the addition to shareholder wealth.

Thus, the method has several strong merits. But the drawbacks make the method inappropriate in certain situations.

2] NPV:

The NPV [net present value] is calculated as: PV of cash inflows-PV of cash outflows, the discount rate used, being the cost of capital appropriate to the risk attached to the cash flows of the project.

The net present value is an absolute figure and represents the net addition to shareholders’ wealth if the project is undertaken. It is so because, the cash inflows are discounted at the cost of capital which, means that the return to the suppliers of capital is set apart and when the sum of the PV of cash inflows exceeds the PV of cash outflows, it means that their capital is paid back. Anything that remains after that is the extra surplus available to the shareholders’ and that represents the addition to shareholders’ wealth.

The rule for acceptance of a project is: NPV>0 Accept the project, otherwise reject.

Projects can also be ranked in the descending order on NPV.

The advantages of NPV method are too strong when compared to the other methods described above.

The advantages are: it considers time value of money; it gives the addition to shareholders’ wealth in current dollars; it considers the entire cash flows of a project; it can consider risk by adjusting the discount rate to suit the risk attached to the cash flows; it can rank projects without conflict, and so on.

Its disadvantages are: the cost of capital is difficult to calculate, especially the cost of equity, which is beset with too many assumptions about market and firm behavior.

But, the advantages of the NPV method makes it the most sought-after method. That is gives the addition to shareholders’ wealth [the goal of financial management] in unambiguous terms is what makes it the king.