The capital investment decisions are very sensitive and crucial for the success of the company in the long run. Therefore, these decisions should be made by conducting a thorough data analysis by adopting the structured capital budgeting process. The capital budgeting process involves analysis of the risks and return of the project in which the firm is seeking to tie up the funds (Bierman & Smidt, 2012). There are various analytical methods employed in the capital budgeting process that provide for analysis of the risks and return. The prominent among those methods are net present value (NPV) analysis, payback period analysis, and the internal rate of return (IRR) analysis. These methods of capital budgeting provides comprehensive analysis of the project’s financial viability (Bierman & Smidt, 2012).
In the context developed above, this report focuses on analyzing the use of NPV, payback period, and IRR for the food quality improvement project to be undertaken by Food and Agriculture Organization of the United Nations. The report discusses the theoretical background of these methods along with expected benefits that Food and Agriculture Organization of the United Nations can make out. Further, the discussion in this report is also extended to the limitations of these methods and the potential obstacles that organization may have to face while going for practical application.
Food and Agriculture Organization (FAO), established in the year 1945, is an agency of federal government that aims to alleviate the poverty and promote the rural development. The agency has taken its initiatives to the global level by collaborating with the governmental agencies of the other countries. The agency is now actively engaged in carrying the rural development programs in Kenya, which is suffering from poverty and hunger. The agency is working to make transition in the communities in Kenya so that they are enabled to find out new ways of accessing the food. The FAO is working for the betterment of the disabled communities of Kenya by lifting the level of agriculture there (FAO, 2017).
Further, FAO is establishing its offices in other countries which are to work in collaboration with the min ministry of agricultural of the country. It established its office in Kenya in the year 1977 and since then it is working in collaboration with the government of Kenya to help country remove poverty and hunger (FAO, 2017). Further, the activities of FAO are aligned with the government’s long term mission and vision. As of now, FAO’s office in Kenya operates with 133 staff members, 36 six field officers.
There are three primary methods of investment analysis such as payback period, net present value, and internal rate of return. The net present value and internal rate of return are two methods of investment analysis that incorporate the concept of time value of money. Further, the payback period method is applied in two ways (Jiambalvo, 2009). In one way, the payback is applied without considering the concept of time value of money and in another; it is applied incorporating the concept of time value of money. The payback period that incorporates the concept of time value of money is termed as the discounted payback period. These methods are crucial to analyze the financial worth of the project (Jiambalvo, 2009).
The payback period is applied to compute the time period within which the company will be able to recover the initial amount of capital expenses incurred. This is perhaps the simplest method to assess to the risk of the project (Femi & Olawale, 2008). The investor gets view of the time period up to which the project can not be made profitable by computing the payback period. Further, it is also helps in selecting the profitable and less risky projects when there are more than one projects are under evaluation. The decision criterion is that the projects having lower payback period are given preference over the others (Femi & Olawale, 2008).
Food and Agriculture Organization (FAO) takes up different project for agriculture farm development and improving the food quality. The payback period could be one of the most appropriate methods in analyzing the projects financial viability. In order to apply the payback period method, the organization will have to collect the information in regards to the cash inflows and the outflows. Further, after collecting the data on cash inflows and outflows, the organization will have to find out the discount rate which will be used in discounting the cash inflows and outflows (Joseph, 2013).
After collecting the required data, payback period method can be applied with ease. The computation of the payback period is comparatively easier than other two methods such as net present value and internal rate of return (Joseph, 2013). An example given below demonstrates the application of payback period in capital budgeting decisions:
|
Payback Period: FAO Kenya Project-Alternative-1 |
||||
|
Years |
Cash Flows ($) |
Present Value |
Cumulative |
|
|
0 |
(900,000.00) |
1.00 |
(900,000.00) |
|
|
1 |
250,000.00 |
0.91 |
227,272.73 |
(672,727.27) |
|
2 |
350,000.00 |
0.83 |
289,256.20 |
(383,471.07) |
|
3 |
450,000.00 |
0.75 |
338,091.66 |
(45,379.41) |
|
4 |
300,000.00 |
0.68 |
204,904.04 |
159,524.62 |
|
5 |
300,000.00 |
0.62 |
186,276.40 |
345,801.02 |
|
Years |
3.22 |
|||
|
Note: Discount rate and cash inflows are based on hypothetical assumptions |
||||
|
Payback Period: FAO Kenya Project-Alternative-2 |
||||
|
Years |
Cash Flows ($) |
Present Value |
Cumulative |
|
|
0 |
(900,000.00) |
1.00 |
(900,000.00) |
|
|
1 |
450,000.00 |
0.91 |
409,090.91 |
(490,909.09) |
|
2 |
350,000.00 |
0.83 |
289,256.20 |
(201,652.89) |
|
3 |
450,000.00 |
0.75 |
338,091.66 |
136,438.77 |
|
4 |
200,000.00 |
0.68 |
136,602.69 |
273,041.46 |
|
5 |
200,000.00 |
0.62 |
124,184.26 |
397,225.72 |
|
Years |
2.00 |
|||
|
Note: Discount rate and cash inflows are based on hypothetical assumptions |
||||
|
Payback Period: FAO Kenya Project-Alternative-3 |
||||
|
Years |
Cash Flows ($) |
Present Value |
Cumulative |
|
|
0 |
(900,000.00) |
1.00 |
(900,000.00) |
|
|
1 |
500,000.00 |
0.91 |
454,545.45 |
(445,454.55) |
|
2 |
200,000.00 |
0.83 |
165,289.26 |
(280,165.29) |
|
3 |
100,000.00 |
0.75 |
75,131.48 |
(205,033.81) |
|
4 |
400,000.00 |
0.68 |
273,205.38 |
68,171.57 |
|
5 |
450,000.00 |
0.62 |
279,414.60 |
347,586.17 |
|
Years |
3.75 |
|||
|
Note: Discount rate and cash inflows are based on hypothetical assumptions |
||||
In this case, FAO can opt for alternative-2 because the payback period of this alternative is 2 years which is the lowest among all.
The net present value is the most commonly use method of capital budgeting. This method provides view of the monetary benefits that the organization will earn by implementing a particular project (Ryan, 2007). The decision criterion as per this method is that the project having the highest monetary benefits will be preferred over the others. In order to compute the monetary benefits, it is crucial for the analyst to determine the series of cash inflows and outflows first and then the discount rate. After this, the cash inflows and outflows are discounted using the discount rate to their present value. The monetary benefits are computed by deducting the present value of cash outflows from the present value of cash inflows. This difference of present value of cash outflows and inflows and is also known as net present value. The projects having positive net present value are considered profitable and the projects with negative net present value are ignored. Further, when there are more than two projects, the projects having higher net present value are selected over the others (Scott, 2012). The data given through following example demonstrate decision making using net present value method:
|
NPV: FAO Kenya Project-Alternative-1 |
|||
|
Years |
Cash Flows ($) |
Present Value |
|
|
0 |
(900,000.00) |
1.00 |
(900,000.00) |
|
1 |
250,000.00 |
0.91 |
227,272.73 |
|
2 |
350,000.00 |
0.83 |
289,256.20 |
|
3 |
450,000.00 |
0.75 |
338,091.66 |
|
4 |
300,000.00 |
0.68 |
204,904.04 |
|
5 |
300,000.00 |
0.62 |
186,276.40 |
|
Years |
|
345,801.02 |
|
|
Note: Discount rate and cash inflows are based on hypothetical assumptions |
|||
|
NPV: FAO Kenya Project-Alternative-2 |
|||
|
Years |
Cash Flows ($) |
Present Value |
|
|
0 |
(900,000.00) |
1.00 |
(900,000.00) |
|
1 |
450,000.00 |
0.91 |
409,090.91 |
|
2 |
350,000.00 |
0.83 |
289,256.20 |
|
3 |
450,000.00 |
0.75 |
338,091.66 |
|
4 |
200,000.00 |
0.68 |
136,602.69 |
|
5 |
200,000.00 |
0.62 |
124,184.26 |
|
Years |
|
397,225.72 |
|
|
Note: Discount rate and cash inflows are based on hypothetical assumptions |
|||
|
NPV: FAO Kenya Project-Alternative-3 |
|||
|
Years |
Cash Flows ($) |
Present Value |
|
|
0 |
(900,000.00) |
1.00 |
(900,000.00) |
|
1 |
500,000.00 |
0.91 |
454,545.45 |
|
2 |
200,000.00 |
0.83 |
165,289.26 |
|
3 |
100,000.00 |
0.75 |
75,131.48 |
|
4 |
400,000.00 |
0.68 |
273,205.38 |
|
5 |
450,000.00 |
0.62 |
279,414.60 |
|
Years |
|
347,586.17 |
|
|
Note: Discount rate and cash inflows are based on hypothetical assumptions |
|||
It could be observed that the alternative-3 has the highest net present value of $397,225.72; therefore, the management can prefer this alternative over the others.
The internal rate of return is computed to determine the return that the firm will earn by investing in the project under evaluation. In order to compute the internal rate of return, the firm needs to collect the information pertaining to the cash inflows and outflows. Further, the firm will also have to work out the minimum rate of return expected from the project (Weygandt, Kimmel, & Kieso, 2009). The decision criterion under this method is that the project earning internal rate of return higher than the minimum required return of the firm are selected while the rest are rejected. The computation of internal rate of return becomes difficult in certain situation due to unusual cash flow series. In case of unusual cash flow series involving more than one cash outflow events at different time periods, the computation of internal rate of return does provide accurate results (Weygandt, Kimmel, & Kieso, 2009). The following example demonstrates the application of IRR method in investment evaluation:
|
IRR: FAO Kenya Project-Alternative-1 |
|
|
Years |
Cash Flows ($) |
|
0 |
(900,000.00) |
|
1 |
250,000.00 |
|
2 |
350,000.00 |
|
3 |
450,000.00 |
|
4 |
300,000.00 |
|
5 |
300,000.00 |
|
24% |
|
IRR: FAO Kenya Project-Alternative-2 |
|
|
Years |
Cash Flows ($) |
|
0 |
(900,000.00) |
|
1 |
450,000.00 |
|
2 |
350,000.00 |
|
3 |
450,000.00 |
|
4 |
200,000.00 |
|
5 |
200,000.00 |
|
29% |
|
IRR: FAO Kenya Project-Alternative-3 |
|
|
Years |
Cash Flows ($) |
|
0 |
(900,000.00) |
|
1 |
500,000.00 |
|
2 |
200,000.00 |
|
3 |
100,000.00 |
|
4 |
400,000.00 |
|
5 |
450,000.00 |
|
24% |
It could be observed that the internal rate of return of 29% is the highest in case of alternative-2, which implies that the alternative would be the most profitable one for FAO. Further, it can also be noted that IRR of all three alternatives is higher than the minimum required rate of return of 10%, which indicates that all three alternatives are profitable.
As has been iterated again and again that the decisions to make capital investment are crucial for the organizational success, therefore, the management needs to be strategic and vigilant in making capital investment decisions. There has to be thorough analysis of the risk and benefits associated with the capital investment to ensure that the firm gets value addition by putting the money on stake (Riahi-Belkaoui, 2001). The most essential advantage of applying the capital budgeting techniques is that the firm gets a thorough analysis of the risks and returns done before making investment. Resultantly, the firm does not go into making the investment decision blindly and that helps the firm to build value and grow exponentially. Further, the investment analysis techniques such as net present value, payback period, and internal rate of return differ from each other in terms of advantages and disadvantages. The net present value provides estimation of the money value of the benefits, IRR provides evaluation of the benefits in terms of rate of return, and payback provides estimation of the time period (Riahi-Belkaoui, 2001).
Overall, the investment analysis techniques are applied to analyze the investment alternatives from all the angles as far as financial aspects are concerned. Thus, FAO, which undertakes various projects related to land development and food quality improvement, can be benefited greatly by adopting the investment analysis techniques (Riahi-Belkaoui, 2001). FAO undertakes projects which involve high amount of investment and long time duration. Thus, the money on stake is huge in the projects undertaken by FAO. The investment analysis technique would help the organization to set up a standard process of identifying the risk and returns of various alternatives. Thus, it will help in improving the overall decision making process in the company (Riahi-Belkaoui, 2001).
There are many advantages of adopting and implementing the investment analysis techniques as discussed in the above section. However, it is not easy to implement the investment analysis techniques. There are many obstacles which might come in the way of Food and Agriculture Organization while implementing the investment analysis techniques. Firstly, FAO will face problems of change in the existing processes and procedures of managerial decision making (Elearn, 2012). The employees are generally resistance to change, therefore, managing that change and ensuring that the employees do not resist from change will be a challenge before the organization. Apart from this, assembling the resources and technologies required to implement the investment analysis techniques also becomes an obstacle in front of the organization (Elearn, 2012).
In addition to the above, the technicalities of a particular investment analysis technique may also bring obstacles to the organization. For instance, the payback period does not fit for analysis of all types of projects. Further, the application of IRR technique is controversially and in certain situations it may be impossible to arrive at the meaningful results using IRR. For instance, in case when the series of cash flows involves cash outflows apart from the initial cash outflows, the application of IRR would not provide meaningful results (Drury, 2008). The NPV technique provides valid solution, but it also has limitations. In analyzing the mutually exclusive projects, the NPV technique provides for selection of the project giving highest NPV, but the project giving highest NPV may involve high investment also. Thus, the analysis by NPV method does not lead to rationale decision in certain cases (Drury, 2008).
Apart from the above, FAO is a government agency that works for social causes. Thus, the agenda of FAO is to work for betterment of the society keeping the profit as the secondary objective. In that case, FAO may go to implement the project, considering the social objectives in mind, though the project is not looking financial beneficial (Drury, 2008).
Conclusion
The discussion carried out in this report relates to the application of project evaluation techniques such as NPV, IRR, and Payback period. The report provides a thorough discussion on the theoretical background as well as practical application of these investment analysis techniques. The Food and Agriculture Organization of the United States has been taken to understand the application of investment analysis techniques. From the overall discussion, it could be articulated that the capital investments involve high risk and therefore, it is imperative to carry out the analysis of risk and returns thoroughly. Further, in order to supplement the analysis of risk and return thoroughly it is important to have in place a standard process of investment analysis or capital budgeting. The standard process of capital budgeting involves implementation of the methods such as net present value, payback period, and internal rate of return. Further, it has been observed that the implementation of the standardized process of investment analysis is not free from obstacle. The major obstacle in this regards has been found out as the management of change in the managerial decision making processes and procedures.
Reference
Bierman, H & Smidt, S. 2012. The Capital Budgeting Decision, Ninth Edition: Economic Analysis of Investment Projects. Routledge.
Drury, C. 2008. Management and Cost Accounting. Cengage Learning EMEA.
Elearn. 2012. Change Management Revised Edition. Taylor & Francis.
FAO. 2017. FAO in Kenya. Retrieved March 22, 2017, https://www.fao.org/kenya/fao-in-kenya/en/
FAO. 2017. Transitioning communities adopt agriculture in Kenya. Retrieved March 22, 2017, from https://www.fao.org/kenya/news/detail-events/en/c/445480/
Femi, A. & Olawale, O. 2008. The Importance of the Payback Method in Capital Budgeting Decision. Retrieved March 22, 2017, from https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.619.726&rep=rep1&type=pdf
Jiambalvo, J. 2009. Managerial Accounting. John Wiley & Sons.
Joseph, C. 2013. Advanced Credit Risk Analysis and Management. John Wiley & Sons.
Riahi-Belkaoui, A. 2001. Evaluating Capital Projects. Greenwood Publishing Group.
Ryan, B. 2007. Corporate Finance and Valuation. Cengage Learning EMEA.
Scott, P. 2012. Accounting for Business: An Integrated Print and Online Solution. OUP Oxford.
Weygandt, J.J., Kimmel, P.D., & Kieso, D.E. 2009. Managerial Accounting: Tools for Business Decision Making. John Wiley & Sons.
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