Capital Budgeting Decisions: Annual Worth, Present Worth And Internal Rate Of Return

The Significance of Annual Worth and Internal Rate of Return for Capital Budgeting Decisions

Concepts of annual worth, present worth and internal rate of return is very significant for capital budgeting decisions:

It refers to the process of discounting the future cash flows of the company for the various variables that are present in the economy and might affect the real value of the cash flows received by the entity. The factors that can affect the real value include inflation rate, the systematic risks undertaken by the investors and the returns that is expected by the shareholders of the company (Daylan & Ciliz, 2016). 

The percentage of the returns that is being given out by project to the company is termed as the internal rate of return. It must be ensured that the internal rate of return of the project must be more than the cost of capital of the company. The cost of capital is the amount that is paid by way of interest and the repayment of the principle to the lenders of the company. If the internal rate of return will be less than this cost of capital of the company no real value creation will take place in respect of the shareholders of the company. It is seen that net present value of the project may be positive and still the project is rejected due to the increased amount of cost of capital of the company.

The value in terms of revenue that is being generated by a project in a span of one year is termed as annual worth of the project. This is one of the most significant information from the point of view of the management of the company in respect of the capital budgeting decisions taken up by it. The reason being that using this information the company is able to determine the number of years it will take to recover the entire amount of investment being made by the company in the project.

Calculation of the Annual Worth of different Alternatives Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
Particular	A	B	C	D
Supply units	5000	5000	5000	5000
Sales price per unit	$3.00	$3.00	$3.00	$3.00
Sales (1)	$15,000.00	$15,000.00	$15,000.00	$15,000.00
Fixed Cost	$10,000.00	$14,000.00	$20,000.00	$30,000.00
Capital Recovery Factor	0.22960738	0.22960738	0.22960738	0.22960738
(A/PIN) (2)	$2,296.07	$3,214.50	$4,592.15	$6,888.22
Salvage value	$500.00	$700.00	$1,000.00	$1,500.00
Sinking Fund factor	0.12960738	0.12960738	0.12960738	0.12960738
(A/F, I, N) (3)	$64.80	$90.73	$129.61	$194.41
Annual Labor cost (4)	$9,000.00	$7,500.00	$5,000.00	$3,000.00
Annual Power and maintenance cost (5)	$500.00	$800.00	$1,000.00	$1,500.00
Annual Worth (1-2+3-4-5)	$3,268.73	$3,576.22	$4,537.46	$3,806.19

Calculation of the Present  Worth of different Alternatives
Particular	A	B	C	D
Sales	$15,000.00	$15,000.00	$15,000.00	$15,000.00
Less:
Annual Labor cost	$9,000.00	$7,500.00	$5,000.00	$3,000.00
Annual Power and maintenance cost	$500.00	$800.00	$1,000.00	$1,500.00
Depreciation	$1,583.33	$2,216.67	$3,166.67	$4,750.00
Taxable Income	$3,916.67	$4,483.33	$5,833.33	$5,750.00
Less:
Tax Payment	$1,175.00	$1,345.00	$1,750.00	$1,725.00
Net Income after tax	$2,741.67	$3,138.33	$4,083.33	$4,025.00
Add:
Depreciation	$1,583.33	$2,216.67	$3,166.67	$4,750.00
Annual Cash inflow after tax	$4,325.00	$5,355.00	$7,250.00	$8,775.00
Present value factor of Annuity	4.3553	4.3553	4.3553	4.3553
Present Value of cash inflow after tax	$18,836.50	$23,322.42	$31,575.64	$38,217.41
Salvage Value	$500.00	$700.00	$1,000.00	$1,500.00
Present value factor	0.56447393	0.56447393	0.56447393	0.56447393
Present value of salvage	$282.24	$395.13	$564.47	$846.71
Fixed Cost (initial Investment)	$10,000.00	$14,000.00	$20,000.00	$30,000.00
Present Worth	$9,118.74	$9,717.55	$12,140.11	$9,064.12

Calculation of IRR of different Alternatives
Particular	A	B	C	D
Year 0	-$10,000.00	-$14,000.00	-$20,000.00	-$30,000.00
Year 1	$18,836.50	$23,322.42	$31,575.64	$38,217.41
Year 2	$18,836.50	$23,322.42	$31,575.64	$38,217.41
Year 3	$18,836.50	$23,322.42	$31,575.64	$38,217.41
Year 4	$18,836.50	$23,322.42	$31,575.64	$38,217.41
Year 5	$18,836.50	$23,322.42	$31,575.64	$38,217.41
Year 6	$19,336.50	$24,022.42	$32,575.64	$39,717.41
Internal Rate of Return	188%	166%	157%	126%

The method of the conventional benefit cost ratio contains the net revenue that has been received from the project by the company and the denominator FO the formula contains the costs that have been incurred by the company in respect of the project. On the other hand, in case of the modified benefit, cost ratio the numerator of the formula contains the revenue generated by the project minus the operating costs incurred and the maintenance costs incurred by the management in the project and the denominator contains only the initial cost incurred in respect of the project (Ciroth et al., 2015).

Calculation of the Annual Worth and Present Worth of Different Alternatives

There are differences in the formulas used up by both of the methods but the recommendation that is being received by the methods is same in both the cases. The reason being that in both the cases, the numerator is represented by the revenue that has been generated by the project and the numerator is representing the costs that have been incurred by the company. If the revenue generated by the project is more than the costs incurred then the project will be accepted and in other case its will be rejected.

If the numerator of the methods is more than the denominator the methods will yield a result that will be more than one and incase the denominator is more than the numerator the answer will be less than one. Hence, in case the answer is more than one the project will be accepted and if the answer is less than one the project will be rejected. 

Calculation of Conventional B/C Ratio Value using Present Worth method
Particulars	Machine A	Machine B
Fixed Costs	$20,000.00	$30,000.00
Salvage Value	$2,000.00	$0.00
Annual receipt	$150,000.00	$180,000.00
Annual Disbursement	$138,000.00	$170,000.00
Present worth Factor of Annuity	6.144567106	6.144567106
Present worth Factor of Single payment	0.385543289	0.385543289
Present worth of benefit	$921,685.07	$1,106,022.08
Present worth of annual disbursement	$847,950.26	$1,044,576.41
Present value of salvage	$771.09	$0.00
Initial Cost	$20,000.00	$30,000.00
B/C Ratio value	1.06	1.03

Calculation of Modified B/C Ratio Value using Present Worth method
Particulars	Machine A	Machine B
Fixed Costs	$20,000.00	$30,000.00
Salvage Value	$2,000.00	$0.00
Annual receipt	$150,000.00	$180,000.00
Annual Disbursement	$138,000.00	$170,000.00
Present worth Factor of Annuity	6.144567106	6.144567106
Present worth Factor of Single payment	0.385543289	0.385543289
Present worth of benefit	$921,685.07	$1,106,022.08
Present worth of annual disbursement	$847,950.26	$1,044,576.41
Present value of salvage	$771.09	$0.00
Initial Cost	$20,000.00	$30,000.00
B/C Ratio value	3.83	2.05

Calculation of the After Tax Cash flow of the Leasing alternatives
Particulars	1	2	3	4	5	6	7	8	9	10
Lease Cost	80000	60000	50000	50000	50000	50000	50000	50000	50000	50000
Other costs	4000	4000	4000	4000	4000	4000	4000	4000	4000	4000
Total Costs	84000	64000	54000	54000	54000	54000	54000	54000	54000	54000
Tax savings on expenses	25200	19200	16200	16200	16200	16200	16200	16200	16200	16200
After Tax Cash Flow	58800	44800	37800	37800	37800	37800	37800	37800	37800	37800

Calculation of Equivalent Annual cost for the alternative ($)
Particulars	1	2	3	4	5	6	7	8	9	10
After Tax Cash Flow	56000	42000	35000	35000	35000	35000	35000	35000	35000	35000
PV factor	0.9091	0.8264	0.7513	0.6830	0.6209	0.5645	0.5132	0.4665	0.4241	0.3855
PV of Cash flow	50909	34711	26296	23905	21732	19757	17961	16328	14843	13494
Net Present Value	239936
Annuity Factor	6.144567106
Equivalent Annual Leasing Costs	39048
Other costs	4000
Equivalent Annual Cost	43048

Calculation of equivalent Annual cost of alternative options
Particulars	Keep X	Replace X with Y	Replace X with Z
Initial Cost	$0.00	$100,000.00	$160,000.00
Annual Maintenance and Operating cost	$90,000.00	$70,000.00	$60,000.00
Salvage Value	$0.00	$30,000.00	$50,000.00
PVAs Factor	0.3855433	0.385543289	0.385543289
PV of Salvage	$0.00	$11,566.30	$19,277.16
Net Initial Cost	$0.00	$88,433.70	$140,722.84
Annuity Factor	6.1445671	6.144567106	6.144567106
Equivalent Annual Cost	$90,000.00	$84,392.18	$82,901.99

The present reports presents the various ways in which the accounting tools such as life cycle costing are being used by the management and the same can be integrated in the decision making and monitoring process of the management. The integration of these tools ensures that the decisions taken up by the management ensures that value is being created by it for the stakeholders of the company (Bierer et al., 2015). Along with it certain gaps present within the operations of the Qantas group is identified. The identification of these gaps will ensure that the company is able to find ways in which these gaps can be alleviated by the company. After conducting the process of identification several recommendations will be made to the management of the company.  

The availability of various accounting and the management tools has helped immensely in improving the decision making process of the management. However, these tools also carry with them certain gaps in respect of their application. The Quanta’s group is facing these gaps in the process of their implementation due to the unique features and the inherent characteristics of the tools used by the management. The management of the company must not deviate from using these tools effectively the reason being that the loss due to the gaps present is less than the value that is being provided by these tools. The management should focus its efforts in respect of better implementation of these tools. The Amin motive of pointing out the gaps present is to ensure ways in which these can be alleviated rather than determining the utility provided by them to the management. Certain gaps that have been found in the implementation process of the quanta’s group are as follows:

1. For the purpose, FO nominal cash flows the management must make use FO the nominal cash flows of the company. In case the management of the company is making use of the actual rates, it must factor in the fluctuations in the price level index and the variability in the inflation rate of the economy.
2. In the process of monitoring of the costs incurred by the company, the management must factor in the various systematic risks that are being incurred by the investors of the company. The need for factoring in the risks undertaken by them arises because in return of the systematic risk incurred by them, they expect significant amount of returns from the company.
3. For assigning the weights, the management of the company mist make sure to utilise the market value of the various financial resources used by it. It is very much possible that the marketing value fo these resources may not be readily available with the management, in those cases the management must makes sure to utilise the available information with it in this respect.
4. For conducting the capital budgeting decisions of the company, the management of the company make use FO the discounting rates extensively. It must be ensured on the part of the management that the discounting rate that is being used makes sure to factor in variables like the fluctuations in the inflation rates of the economy, the variability involved in the estimated future cash flows of the company, the systematic risk that are being borne by the investors of the company etc. In addition to these factors, there are wide ranges of other factors that affect the rates and these factors may or may not be in the control of the management.  

Conventional and Modified Benefit Cost Ratios for Decision Making

The management must ensure the generation of the cash flows by the company on a consistent basis. The process of generation of the revenue of the company starts from the process FO continuous monitoring of the costs that are being incurred by the company and their respective implication on its operations. In the absence of the proper monitoring of the costs that are incurred by the company the use of various accounting and the management tools by the management will become ineffective. In addition to this, it is of utmost importance that the internal control systems of the company are kept in full functioning situations (Woon & Lo, 2016). The internal control systems assist the management in the cost control procedure of the company. Hence, some of the recommendations to be made to the management in this respect are as follows:

1. For the purpose FO increasing the reliability FO the airlines due consideration must be given by the management regarding the safety of the aircraft. Because in the case of an airline company the priority should always be the safety of the passengers. Any mistake on the part of the management of the company can lead to loss of lives. Hence, the procedures for ensuring the safety of the airlines must be given due focus and utmost attention on immediate basis and the required changes from time to time must be made in them.
2. The discounting rate used up by the management must factor in various factors that affect the financial performance and the financial position of the company. Some of the factors that should be taken care of by the discounting rate include variability fluctuations in the inflation rate of the economy, the changes that might occur in eh pattern of the cash flows of the company and the various external and internal factors that might affect the operations of the company in the future.
3. For ascertaining, the weights to be used for the purpose of capital budgeting decisions the management must make sure to utilise the market values of the financial sources that have been used by the company.

Conclusion:

The cost implications of the decisions that re taken up by the management severely affects the future cash flows and the revenue generation opportunities of the company. The decisions regarding the acceptance of the prospective projects must be made by keeping in mind the returns that will be generated by them in respect of the shareholders due importance must be given by the management to the decisions regarding the transactions involving fixed assets of the company. The reason for this is that for granting revenues the company will have to make use FO the fixed assets available with it. In addition to that, the management of the company must make sure to use the right kind of tools for making its decisions. The effective utilisation of the tools by the management will ensure that the decisions taken by it adds value to the shareholders of the company in the end.

Reference

Bierer, A., Götze, U., Meynerts, L., & Sygulla, R. (2015). Integrating life cycle costing and life cycle assessment using extended material flow cost Accounting. Journal of Cleaner Production, 108, 1289-1301.

Ciroth, A., Hildenbrand, J., & Steen, B. (2015). Life cycle costing. Sustainability Assessment of Renewables-Based Products: Methods and Case Studies,, 215-228.

Daylan, B., & Ciliz, N. (2016). Life cycle assessment and environmental life cycle costing analysis of lignocellulosic bioethanol as an alternative transportation fuel. Renewable Energy, 89, 578-587.

Woon, K. S., & Lo, I. M. (2016). An integrated life cycle costing and human health impact analysis of municipal solid waste management options in Hong Kong using modified eco-efficiency indicator. Human Resources Management, Conservation and Recycling, 107, 104-114.