Assessing Capital Budgeting Methods: Techniques And Tools

Capital Budgeting Theory and Practice

The capital budgeting is an important basement tool that is applied by the investment firms and companies for the assessment of the viability of the project. The capital budgeting is the key tool that is applied by the management of the company for the purpose of the evaluation of the various investment project of the companies (Wnuk-Pel, 2014). The different investment tools such as the net present value, internal rate of return and the payback period of the project could well address the viability and visibility of the project. The aim of the investment project is to assess the viability in terms of the viability of the project and the return the project would be generating from the same. Corporate investment decision making is based on various assumptions and forecasts that are applied by the management of the company for the purpose of the investment. The required rate of return from a project is evaluated after assessing the project based on the risk and return provided by the project and other various aspects that can significantly affect the profitability and return from the project (Pfeiffer et al. 2016).

Return and sustainability of the investment project are the two key aspects of a capital budgeting and the same should be taken into consideration while evaluating the project. The application of various factors and approaches like sensitivity analysis and scenario analysis can help the company in the evaluation of the viability of the project at various stages (Chittenden & Derregia, 2015). Risk assessment plays a crucial role in the overall development of the project. Different investment tools are applied in the context of evaluation of the project as each method has its own merits and demerits and inclusion of various factors and approaches will guide the company in the overall development and sustainability of the project (Kengatharan, 2016).

Sensitivity Analysis: The sensitivity analysis shows the key factors that are associated with the company and the change in the final output of the investment project if the key factor for the investment project changes (Burns & Walker, 2015). Sensitivity analysis is a key factor that is considered by the company for assessing the overall changes when the key factors of the project like discount rate, cash flows and the level of interest rate changes in the project. Assessment of changes in these factors and the value of final output can be well linked on an overall basis for the company. Investment manager should apply the concepts of the various investment tools so that they can assess the same thereby analysing the viability and success of the project in terms of return and risk.

Factors Determining the Selection of Capital Budgeting Methods

Scenario Analysis: The scenario analysis shows the changes in the key factors and various scenarios that should be incorporated for the company. Scenario analysis shows the changing profitability, interest rate and various other key factors of the company that can significantly influence the operations of the company. The scenario analysis reflects the changing business condition and output of the same after the inclusion of the various business conditions and factors that were taken into consideration. The scenario analysis of the company could well indicate the viability and success of the company in terms of the operations of the company and viability (Santos et al. 2014).

Net Present Value: The net present value of the company shows the profitability of the project in terms of the assessment and viability of the project. The net present value of the project shows the assessment of the project and the return generated in terms of the cash inflows of the project. The NPV is considered a key measure for the evaluation of the profitability of the project as the same considers the concept of shareholder’s wealth maximisation concept.

Internal Rate of Return: The internal rate of return shows the assessment of the project in terms of the percentage. The return generated by the project and the overall feasibility of the project. The internal rate of return is a key measure that is applied by the management of the company for the purpose of comparison.

Crucial factors depending on the investment project like timing of the cash flows and the size of the cash inflows from the project is also a key factor that should be taken into consideration for the purpose of the analysis of the company. Application of key investment tools like payback period and discounted payback period can be applied by the company for the purpose of the analysis of the recovery of the total invested cash flows. Risk is of uncertain nature and the timing of the cash flows and the return on investment may vary depending on certain factors which are directly attributed to the project. Application of risk assessment tools like scenario analysis and sensitivity analysis in the investment project can help the company in forecasting the various scenarios which the company can face and the expected result from the same. Forecasting and planning is an efficient way of implementing management strategies that can help the organisations and institutions in better handling of various situations and hurdles faced by the company.

Investment Tools for Viability Assessment

Thus it is important that the investment projects selected by the company aims at maximising the wealth of the shareholder. Risk and return  is also an important factor that should be assessed for the investment project and the same should be compared in contrast to the overall belief of the management.

The analysis of the Berry Mount Manufactures can be done on the basis of the several investment assessment tools which were applied for assessing the financial feasibility and viability of the project. The key investment tools that were applied for the investment project for the purpose of investment consideration and evaluation of the profitability of the project were the Net Present value, internal rate of return, payback period and discounted payback period of the project.

The net present value of the project that was determined for the project and the same was around $1,624,437 for the project. The net present value is greater than zero indicating that the project is financially viable for the purpose of the investment. Acceptance of the investment project will lead to the shareholder’s wealth creation (Rich & Rose, 2014). The management of the company should evaluate other key factors that shows us the various aspect of the condition and the viability of the project. The internal rate of return shows the amount of return generated by the project in terms of percentage. The IRR of the project was around 17% this shows that the investment project would be yielding an all total of 17% of return on the initial capital invested. The internal rate of return from the project is much higher than the required rate of return from the project.  

Payback Period shows the recovery of the initial investment of project in the form of cash inflows over the life of the project. The payback period for the project was around 3.49 years reflecting that the company will be able to recover the initial set of amount in the given frame. The discounted payback period is more classified way of calculating and evaluating the recovery of the initial amount as the same considers the discount rate for evaluating the discounted cash flow received from the investment project (Daunfeldt & Hartwig, 2014). The discounted cash flow from the project was around 4.29 years reflecting the company will be able to recover the initial set of investments in the given time frame.

Year	Total Cash Inflows/(Outflows)	Cumulative Cash Flow	Discount Rate	Discounted Cash Flow	Cumulative DCF
0	-8000000	-8000000	10%	-8000000	-8000000
1	1954000	-6046000	10%	1776363.636	-6223636.364
2	2216500	-3829500	10%	1831818.182	-4391818.182
3	2479000	-1350500	10%	1862509.391	-2529308.79
4	2741500	1391000	10%	1872481.388	-656827.4025
5	3674000	5065000	10%	2281264.941	1624437.538

Investment Results/Output
Payback Period	3.49
Discounted Payback Period	4.29
Net Present Value	1624437.54
Internal Rate of Return (IRR)	17%

Thus, from the above analysis and the results from the investment project shows that the project should be accepted so that the same creates values for the shareholders of the company.

Reference

Burns, R., & Walker, J. (2015). Capital budgeting surveys: the future is now.

Chittenden, F., & Derregia, M. (2015). Uncertainty, irreversibility and the use of ‘rules of thumb’in capital budgeting. The British Accounting Review, 47(3), 225-236.

Daunfeldt, S. O., & Hartwig, F. (2014). What determines the use of capital budgeting methods?: Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), 101-112.

Kengatharan, L. (2016). Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), 15-38.

Pfeiffer, A., Millar, R., Hepburn, C., & Beinhocker, E. (2016). The ‘2 C capital stock’for electricity generation: Committed cumulative carbon emissions from the electricity generation sector and the transition to a green economy. Applied Energy, 179, 1395-1408.

Rich, S. P., & Rose, J. T. (2014). Re-examining an old question: Does the IRR method implicitly assume a reinvestment rate?. Journal of Financial Education, 152-166.

Santos, L., Soares, I., Mendes, C., & Ferreira, P. (2014). Real options versus traditional methods to assess renewable energy projects. Renewable Energy, 68, 588-594.

Wnuk-Pel, T. (2014). The practice and factors determining the selection of capital budgeting methods–evidence from the field. Procedia-Social and Behavioral Sciences, 156, 612-616.