Discuss about the Capital Budgeting and Investment Analysis.
The present report aims to present an analysis of the investment proposals that are considered by SD Ltd for investing in new machinery. The capital budgeting decisions are very crucial for a business entity in order to select the most profitable investment option that will improve the business performance in future context. The capital budgeting can be stated to be a step by step process that a business entity uses for determining the benefits of an investment project (Bhimani, 2006). The capital budgeting seeks to analyse the risks and returns of a project and thus help in selecting the most attractive option based on their accountability. There are various techniques of capital budgeting used by project managers for analyzing the profitability of a project that are accounting rate of return, payback period, net present value and internal rate of return. The business entities are able to select the most appropriate investment option as per their requirements based on the results of the capital budgeting techniques. The business entities can predict the future cash flows through the help of capital budgeting decisions for developing their potential growth strategies and objectives (Huang, 2010).
The selection of a most feasible investment strategy is essential for business entities to achieving competitive advantage in the market place and thus ensuring their sustainable growth and development (Peterson and Fabozzi, 2004). The business expansion and development depends on the capital budgeting decisions and in this context this report evaluates the investment options presented before SD Ltd. The SD Ltd is considering to either implementing G120 or Z125 machinery for automating its production and thus reducing its operational cost. In this context, the report provides an analysis of different capital investment appraisal measures in order to select the most appropriate option. Critical Discussion of Usefulness of the Respective Capital Investment Appraisal Measures Recommendations for Selection of an Option
It is also known as average rate of return (ARR) and is used for selecting the feasibility of an investment option. It is calculated through dividing the average annual accounting profit to be realized from a project by initial investment. The project is accepted if the ARR is greater than required rate of return (Baker and English, 2011). The main advantage of use of this method is that is easy to implement and to use for analyzing the feasibility of a project (Besley and Brigham, 2008). The method is not largely used by the project managers during capital budgeting decisions as it does not take into account the concept of time value of money that can impact the profit generated from a project with change in the interest rates. The ARR method is also mainly based on computing the profits that can be easily manipulated with the change in deprecation methods. Thus, it can provide misleading results during analysis and selection of different investment options. It does not take into account the cash flows realized from an investment proposal and therefore do not provide accurate results (Nwogugu, 2017).
In addition to this, the method also does not take into consideration the increase in risks of the project over long period of time. The method also is not appropriate for comparison of different projects as it does not consider other factors that should be evaluated for comparison of different projects. The accounting rate of return for the two given options for investment in machinery is different as given in the table. The ARR for G120 is 18% and for the Z125 is 14.7% and therefore on the basis of ARR the SD Ltd is recommended to select the investment proposal of investing in G120 machinery (Wilson, 2015).
The payback period is referred to as time-period required for recovering the cost of an investment. The payback period helps in taking decisions regarding to invest in a project or not. The longer the payback period of a project less it is suitable for investment purpose. The concept is very simple to be used and also to be understood. It can be calculated even without the use of a calculator. The method specifically emphasizes on the time required to recover the cost of a project and as such provides an assessment of its risk. Therefore, it can be used to compare the risks of different projects on the basis of their payback periods (Holmén and Pramborg, 2007).
The method also has a drawback of not considering the concept of time value of money while determining the feasibility of a project. It only focuses on assessing the liquidity of a project and does not consider its profitability. The method does not take into account the cash flows that will be received after the payback period. As per this method, it can be said that SD Ltd should consider the project G120 for investment in comparison to Z125 as it have less payback period (Mushaho and Mbabazize, 2015).
The net present value can be stated as the difference between cash inflows and the cash outflows that is calculated for analyzing the profitability of a project (McClure, 2004). It is calculated through the use of following formula:
The NPV evaluates the feasibility of a project through calculation and summation of all the discounted cash flows of a project that is either positive or negative. Thus, it is highly sensitive to discount rates. The project is accepted if it is expected to generate positive IRR and rejected if it provides negative IRR. The NPV method estimates the feasibility of a project on the basis of the cost of capital and the risk involved in estimating the future cash flows. The NPV method also is very useful for determining the expected value a project will create for a company (Bierman and Smidt, 2003).
The project managers use the capital budgeting technique of NPV for calculating the cash flows of different investment options separately. However, its biggest disadvantage is that it is based on numerous assumptions about the cost of capital of a company. Therefore, if the cost of capital of an entity is considered to be very low it can result in making sub-optimal investments and it is very high then it can result in not selection of many appropriate investment options. As such, based on the NPV of the given two investment options for SD Ltd, the Z125 machinery investment option should be selected as its NPV is £420,194 and £284,864 (Bierman and Smidt, 2007).
The internal rate of return (IRR) in capital budgeting decisions is used to assess the profitability of potential investment options. It is said to be a discount rate at which the NPV of all the cash inflows from a project becomes zero. It is thus used for calculating the breakeven point of a project. The most significant advantage of the use of this method is that it considers the concept of time value of money in analyzing the feasibility of a project. Also, it is simple to understand and so largely used by accounting managers in capital budgeting decisions. The decisions regarding the acceptance or rejection of a project in this technique is not based on the required rate of return. The major disadvantage of the method is that it does not consider the economies of scale Also, it does not analyse the profitability of a project on the basis of the project size. The cash flows are compared with the capital amount and therefore the projects with different capital investment cannot be compared as higher IRR will be obtained from a small project. The IRR method only emphasizes on the estimated cash flows of a project and does not consider the potential costs that can impact its future profitability. The method also cannot be used when the discount rate of a project is not known. As per the internal rate of return, the G120 investment option is selected in comparison to Z125 because it provides larger IRR (Brigham and Ehrhardt, 2007).
On the basis of analysis of all the four capital investment appraisal measures, it can be said that SD Ltd should select the investment option for investing in G120 machinery because it has higher IRR, lower payback period and higher ARR. The lower payback period of G120 investment option indicates that it has minimum risk and therefore it will recover its cost of investment in short period of time. The accounting return of return is also higher which means that G120 investment option will help in generation of more net income in comparison to the other option. The IRR of G120 option is higher indicating that the rate of return of this option is higher in comparison to other. The NPV of Z125 is higher as it evaluates the attractiveness of a project for inviting on the basis of cost of capital. The Z125 is a highly capital intensive project and as such its NPV value is higher in comparison to G120 option. Therefore, the most appropriate investment option for SD Ltd is investing in G120 machinery for improving its production process (Megginson, Lucey and Smart, 2008).
As depicted from the given table, the payback and NPV method of capital budgeting used for analyzing the feasibility of the two given investment options have shown different results. The payback capital budgeting technique favors G120 option as it has lower payback time therefore it will recover its cost in small period of time in comparison to other investment option. On the basis of pay-back method, it can be said that G120 investment option is less risky as it recover its cost of investment quickly. The NPV method favors Z125 option because it provides maximise wealth to the shareholders as it has larger NPV than G120 option. The NPV methods calculate the present value of cash flows and derive the value of a project that will be added to the shareholders wealth. The overall analysis provided by NPV is based o the cost of capital (Peterson and Fabozzi, 2004). The assessment provided by the NPV method can be said to be more reliable and therefore the company can consider the selection of investment option for Z125 machinery. The NPV value can be said to more reliable as it analyses the profitability of a project o the basis of the concept of time value of money and also provides results by considering the cash flows to be realized at the end of a project. Thus, it predicts the best investment option for a company by considering the future changes in the market place (Pogue, 2010).
However, the payback period method is considered to be less reliable than NPV method because the results provided by it have not considered the factor of time value of money. Therefore, the company can select the Z125 machinery investment option as NOV method is more reliable capital budgeting technique in comparison to payback method. However, as per my opinion in the given case the G120 option is less risky because the projects that have payback period less than 3 years are accepted on the basis of their less risk. The Z125 option has more risk as its payback period is more than 3 years. Therefore, the company by selecting the G120 option can reduce its risk and by realizing the breakeven point earlier can re-invest the funds for earning greater profits. Also, the investing in Z125 would require the company to invest its entire capital budget as it requires more capital (Pratt, 2003). Therefore, the company should play safe and is recommended to invest in the projects that have less risk that is in G120 option. Both the option does not consider the project size and therefore on the basis of results of payback period and NPV value, it is suggested that SD Ltd should select the investment option of G120 because it have less risk. The company is not in position of taking higher risk due to capital budget constraints and therefore recommended to select the results obtained from payback period method (Shapiro, 2005). Analysis of Confidence of Finance Director in the given case about achieving IRR would in excess of 15% for both options of G120 and Z125
The IRR (Internal Rate of Return) is regarded as the discount rate at which the net present value of cash flows becomes zero. The internal rate of return is often selected as the best option to accept or reject a project if the other factors are considered to be constant. On the other hand, the net present value is said to be the difference between the present value of cash inflows and outflows. It evaluates the profitability by taking into consideration the value of a dollar in present with that in the future (Hsu, 2005). The NPV and IRR both evaluates the profitability of a project by considering the time value of money and are used in combination by the project managers for analyzing and comparing the investment options. The relation between NPV and IRR can be used to describe the reason for the confidence of finance director that IRR would be greater than 15% for both the investment options. The NPV of a project if is less than zero then IRR is also less than the cost of capital and the project will be rejected (Griff, 2014).
This is because the rate of return of a project is less than the expenditure incurred during carrying the project and therefore it is not able to realize its breakeven point. However, if NPV is equal to zero, then IRR is equal to the cost of capital and the project will be probably rejected as it will provides less return (Al-Ani, 2015). However, if NPV is greater than zero, then IRR is also greater than cost of capital and the project is accepted on the basis of providing it large profitability. As such, in the given scenario, the NPV is calculated through applying the cost of capital to be 15%. The NPV of both the projects as evaluated are positive and therefore it can be said that IRR of both the projects will be above 15%. This is because the IRR is calculated at the discount rate when NPV becomes zero. Therefore, the discount rate of both the projects would be above 15% to arrive at NPV to be zero which is calculated at the cost of capital rate of 15% (Lunkes et al., 2015).
The evaluation of the third investment option of new machinery with cost of £2,080,000 and NPV of £140,800 for SD Ltd can be done through considering the following two assumptions:
Conclusion
Thus, it can be said from the overall discussion held in the report that capital budgeting decisions plays a critical role for achieving success from a capital project. The capital budgeting techniques analyzed in the report, that are, accounting rate of return, internal rate of return, net present value and the payback period are very important for evaluating the potential worth of a project, These techniques provides a base for accepting or rejecting a project under consideration based on its potential profitability and returns. The SD Ltd should select the investment option from the given tow machinery of G120 and Z125 after thorough analysis of the results obtained from the use of capital budgeting techniques. This is essential so that the company can achieve its strategic goals and objectives which it wants to achieve through installation of new machinery. The results obtained from the capital budgeting techniques in combination with the business requirements would decide the selection of the most appropriate investment option.
References
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