Question

Decision Making: Discuss how relevant information is used to make short-term decisions and how pricing affects short-term decisions. Explain the concept of capital budgeting and detail the capital budgeting techniques used to make decisions. This includes, the payback method, the accounting rate of return method, and the discounted cash flow method.

Answer 1

The management must focus on relevant information while making decisions. It is the information related to the future and differs among the available alternatives. After the identification of the relevant information, the management applies an incremental analysis approach for making the decisions in short-term. Thus analyzes fixed costs and variable costs separately using the contribution margin approach while fixing the price.

Capital budgeting is process of analyzing and ranking proposed projects that helps management to determine which ones are deserving of an investment. It consists of various techniques such as net present value, internal rate of return, payback period, profitability index and accounting rate of return.

-- Payback method: Payback period refers to a capital budgeting concept that refers to period of time which is needed for a project to generate a return on investment that cover the original investment made by a company on the initial project cost. This is calculated by dividing the amount of the investment by the projected cash inflow per year. A shorter payback period equates to a higher return on the capital investment. Most of the companies have a maximum acceptable payback period and thus consider those projects whose payback period is normally less than the target number of years. However this method ignores cash flows beyond the payback period, thus ignoring the "profitability" of a project. Moreover overlooks the costs of capital such as interest factor which is a vital consideration in making sound investment decisions

--Internal rate of return: In capital budgeting, projects are usually evaluated by making a comparison on the internal rate of return (IRR) on a project to the rate of hurdle, weighted average cost of capital (WACC) or minimum acceptable rate of return (MARR). When MARR exceeds IRR, then project is rejected; and conversely when MARR is lesser than IRR, then project is accepted. Similarly when IRR is higher than WACC, then the project’s rate of return exceeds the cost of the capital that was invested and should be accepted; and vice-a-versa

-- Discounted cash flow: A discounted cash flow refers to a valuation method that is used for the estimation of the attractiveness of an investment opportunity. The discounted cash flow method to determine firm value is almost solely-driven by the projected performance of the firm into the duration of long-term. It uses future free cash flow projections and afterwards discounts to arrive at a present value estimate, that is used for the evaluating the potential for investment. It derives the cash flow the company will produce into perpetuity, when applicable, and afterwards discounts those cash flows back into today’s dollars (it is also known as net present value (NPV)).