Effective Capital Budgeting: Strategies & Methods

Introduction

Capital budgeting may be a strategy of analysing and comparing substantial future ventures and consumptions to decide which ones are most beneficial. It is the method that the company administration uses to recognize what capital projects will make the greatest returns compared with the funds within the project each venture is positioned by its potential future return, the company administration can choose which one is best to contribute in.CITATION Art19 l 7177 (Pinkasovitch, 2019)According to Solomon: 'Financial management is concerned with the efficient use of important economic resource namely funds.

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1.The importance of capital budgeting to the success of the firmCapital budgeting is the process that helps in planning the investment projects of an organization in long run. It takes all possible considerations into account so that the company can evaluate the profitability of the project. it is useful for evaluating capital investment project such as purchasing equipment, the rebuilding of equipment's etc. The benefit from an investment may be in a form of reduction in cost or in a form of increased revenue.

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The importance of capital budgeting can be understood in a form of its impact on business. Businesses exit to earn profit except for non-profit organisations. Capital budgeting is very important for business as it impacts growth and prosperity of the business in the long term it creates accountability and measurability. Capital budgeting involves two important decisions at once; a financial decision and an investment decision. Taking the project, the business has agreed on making a financial commitment to a project and that includes its own set of risks.

Project delay costs overruns and regulatory restriction that can all delay and increase the costs of the project.

Importance of capital budgeting:

• Long term goals
• Involvement of large number of funds
• Irreversible decision
• Monitoring and controlling the expenditure
• Transfer of information
• Difficulties of investment decision

Maximization of wealth CITATION Edu18 l 7177 (EduPristine, 2018)

Methods to calculate capital budgeting

Capital budgeting methods are used to help the decision making process in capital budgeting and can be as non-discount cash flow methods which include Payback Period, and discounted cash flow which include the Net Present Value(NPV) and Internal Rate of Return(IRR) and Profitability Index(PI).

These are the following methods:

Payback period

This method refers to the period in which the proposal will generate cash to recover the investment made. It simply focuses on money inflows, financial life of the project and the investments made within the project with no consideration to time value of money. Through this method of selection of proposal is based on earning capacity of the project. With the straightforward calculations, choice or dismissal of the project can be done with the offer that will assist with the help of risks involved. The method used is based on the thumb rule it does not consider the significance of time value of cash and so the significant measurements of profitability.

Formula: payback=cash investment /annual cash inflow.

Net Present Value

Companies use the NPV method in for assessing the capital investment recommendations. There can be an uneven cash flow created during different periods of time. This is discounted at the cost of the company. This is often compared with the investments made. If the present value of inflows is more than the outflows, then the project is accepted or rejected. Time value of money is considered in this method and the traits to the company's objectives which is maximizing benefits for the owners. Also it considers the cash flows during the entire residency of the item and dangers of such cash flows through the costs of capital. It requires the use of an estimate to calculate the costs of capital.

Formula: NPV=Present Value(PV)of inflows- Present Value of outflows. When there are two with the positive NPV, then select the project with higher NPV.

Internal Rate Return

IRR is defined as the rate at which NPV is zero. At this rate the present value of cash flows is equal to the cash outflow. The value of cash is also considered. This is the most complex method used in capital budgeting. If IRR is more than the weighted normal costs of capital, then the project is accepted otherwise it is rejected. In case of more than one project at that point the highest IRR is chosen.

Formula: IRR>Costs of capital =accepted project.

IRR>Cost of capital =rejected project. CITATION Vai19 l 7177 (Vaidya, 2019)Profitability Index

Is the ratio of the present value of future cash inflows discounted at the required rate of return to the cash outflow at the investment stag.

Formula: profitability index= present value of cash inflows/ initial investment.

Causes of conflict between NPV and IRR MethodsFor normal projects NPV profiles to cross one project must have both higher vertical axis intercept and a steeper slope than the other. A project's vertical axis intercepts depends on

The size of the project

The size and timing pattern of cash flows large projects and ones with large projects and one with distant cash flows would generally be expected to have high vertical axis intercepts. The slope of NPV profile depends on the timing pattern of cash flows, long term projects have steeper NPV than the short term ones. The NPV profiles can conclude in two situations when mutually exclusive projects differ in scale and when the project cash flows as franchise of L and S.

The underlying cause of ranking conflicts is the reinvestment rate assumption. All DCF method implicitly assume that cash flows can be reinvested at some rate, regardless what is actually done with the cash flows. Since compounding assumes both reinvestment and discounting. NPV and IRR are both found by discounting and they both implicitly assume some discount rate. The NPV calculations is an assumption that cash flows can be reinvested at the project's cost of capital while the IRR calculations assume reinvestment IRR rate. CITATION Fre99 l 7177 (Freman., 1999)

Primary difference IRR and MIRR Internal rate of return is the discounted rate that brings about equality between the present value of expected cash flows and initial capacity outlay.

MIRR expands to modified internal rate return is the rate that equalizes the present value of final cash inflows to the initial zero-year cash outflows.

These are the following differences between IRR and MIRR

Internal rate of return or IRR implies a method of figuring the discounted rate considering internal factors excluding the costs of capital and inflation. On the other hand, MIRR insinuates to the method of capital budgeting which calculates the rate of return by taking into consideration account costs of capital. It is used to utilize the different investments of the same size.

The internal rate of return is an interest rate at which NPV is equal to zero. On the other hand, MIRR is the rate of return at which NPV of terminal inflows is break even to the outflow e.g. investment.

IRR is based on the rule the rule that between time cash inflows are reinvested at the project's IRR Unlike MIRR, cash inflows separated from initial cash flows are reinvested at the firm's return rate.

The accuracy of MIRR is more than IRR as MIRR measures the true rate of return. CITATION Sur17 l 7177 (S, 2017)

Conditions can cause MIRR and NPV methods to produce conflict rankings The MIRR and the NPV always agree on mutually exclusive projects (if MIRR is based on the WACC),but there can be NPV and MIRR conflicts if they both differ in size. Conflicts can still occur when projects differ in scale and in such cases NPV IS USED.

MIRR avoids the problem of the problem of a lot of IRR which can increase when a project has normal cash flows or has negative cash flows after the project has gone into operations.NPV can easily be applied to such situations but MIRR can also overcome the multiple IRR problems because there is only one MIRR for a set of any cash flow.

If two mutually exclusive projects have NPV profiles that interest in the higher right hand quadrant, there may be a conflict ranking between NPV and IRR methods. A conflict between NPV and IRR choice exists for mutually exclusive projects if the costs of capital is less than the crossover time.

Two basic conditions can lead to conflict between NPV and IRR are:

Project size or scale difference exists the cost of one project is larger than the other

Timing difference exists as such cash flows from one project come early years and most of the cash flows from the other cash flows comes later in the year.

When projects are independent, the NPV and the IRR methods both make the same accept/reject choice. When evaluating mutually exclusive projects

CITATION Eug07 l 7177 (Eugene Brigham, 2007)

ADVANTAGES AND DISDAVANTAGES OF CAPITAL BUDGETING METHODSPAYBACK PERIOD ADVANTAGES DISADVANTAGES

1. Simple to compute
2. Provides some information on the risk of the investment
3. Provides a crude measure of liquidity. 1.No concrete decision criteria to indicate whether an investment increases the firm's value
4. Ignores cash flows beyond the payback period.
5. Ignores the time value of money .
6. Ignores the risk of future cash values.

INTERNAL RATE OF RETURN ADVANTAGES 1.Tells whether an investment increases the firm's value.

Considers all cash flows of the project.

Considers the time value of money 4.Considers the risk of future cash flows (through the cost of capital in the decision rule)

DISADVANTAGES.

1. Requires an estimate of the cost of capital in order to make a decision.
2. May not give the value-maximizing decision when used to compare mutually exclusive projects.
3. May not give the value-maximizing decision when used to choose projects when there is capital rationing.
4. Cannot be used in situations in which the sign of the cash flows of a project change more than once during the project's life

DISCOUNTED PAYBACK PERIOD ADVANTAGES

1. Tells whether the investment will increase he firm's value.
2. Considers all the cash flows.
3. Considers the time value of money. 4.Considers the risk of future cash flows. DISADVANTAGES
4. Requires an estimate of the cost of capital in order to calculate the net present value. 2.Expressed in terms of dollars, not as a percentage.

PROFITABILY INDEX ADVANTAGES

1. Tells whether an investment increases the firm's value
2. Considers all cash flows of the project
3. Considers the time value of money
4. Considers the risk of future cash flows (through the cost of capital)
5. Useful in ranking and selecting projects when capital is rationed

DISADVANTAGES

1. Requires an estimate of the cost of capital in order to calculate the profitability index.
2. May not give the correct decision when used to compare mutually exclusive projects.

MODIFIED INTERNAL RATE OF RETURN ADVANTAGES

1. Tells whether an investment increases the firm's value.
2. Considers all cash flows of the project.

Considers the time value of money

1. Considers the riskiness of future cash flows (through the cost of capital in the decision rule) DISADVANTAGES
2. Requires an estimate of the cost of capital in order to make a decision .
3. May not give the value-maximizing decision when used to compare mutually exclusive projects .
4. May not give the value-maximizing decision when used to choose projects when there is capital rationing

NET PRESENT VALUE ADVANTAGES

1. t takes into account Time Value of Money
2. Helps in Decision Making.

DISADVANTAGES

1. No Set guidelines to Determine the Required Rate of Return
2. Cannot be used to Compare Projects of Different Sizes
3. Hidden Costs

CITATION Adv08 l 7177 (Advantage and disadvantages of the different Pamela Peterson-Drake, 2008)CITATION Art19 l 7177 (Pinkasovitch, 2019)7.CLASSIFICATION OF MONEY (M1, M2 M3 AND M4)Different measures of cash supply. Not all of them are broadly utilized and the precise classifications depend on the nation. M0 and M1, moreover called limit cash, ordinarily incorporate coins and notes in circulation and other cash equivalents that are effectively convertible into cash. M2 incorporates M1 additionally short-term time stores in banks and 24-hour cash advertise stores. M3 incorporates M2 additionally longer-term time stores and cash market stores with more than 24-hour development. The precise definitions of the three measures depend on the nation. M4 incorporates M3 also other stores. The term wide cash is utilized to depict M2, M3 or M4, depending on the neighbourhood practice.CITATION fin18 l 7177 (AG, 2018)

ConclusionWe have talked about six capital budgeting choice methods, comparing the methods with one another, and highlighting their relative qualities and weaknesses. Within the handle, we likely made the impression that "sophisticated" firms should use only one strategy within the choice prepare, NPV. In any case, essentially all capital budgeting choices are analyzed by computer, so it is simple to calculate and list all the choice measures: payback and marked down payback, NPV, IRR, altered IRR (MIRR), and productivity list (PI). In making the accept/reject choice, most large, advanced firms calculate and consider all of the measures, since each one gives choice makers with a to some degree different piece of significant data. Payback and reduced payback give an sign of both the risk and the liquidity of a project.

Bibliography BIBLIOGRAPHY Advantage and disadvantages of the different Pamela Peterson-Drake, F. A. U., 2008. Advantage and disadvantages of the different capital budgeting techniques, Florida: Atlantic University .

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Eugene Brigham, M. E., 2007. Financial management theory and practice. 1st ed. ENGLAND : Cengage Learning,.

Freman., D. M., 1999. which financial evaluation technique, NPV or IRR is better to use when selecting the best project among a mutually exclusive projects . In: E. a. J. F. Brigham, ed. Fundemtals of financial management 2nd. London: The Dryden Press, p. 7 of 19.

Pinkasovitch, A., 2019. ADVANTAGES AND DISADVANTGES OF CAPITAL BUDGETING METHODS. [Online] Available at: Thursday September 2019].

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Vaidya, D., 2019. Financial analysis, New york : Wallstreetmojo.