4.2. Capital Budgeting Techniques Flashcards
Does not contain information or examples of the techniques, only a summary, advantages and disadvantages.
Net present value summary…
Discounts a series of cash flows to assess the profitability of a project.
This considers the time value of money and considers the benefits a project will bring to a company, whilst considering its costs.
Financial managers can use sensitivity analysis to create a range of NPV calculations, using different possible discount rates, to determine if a project’s NPV.
The greater the discount rate, the greater the cost of capital.
Net present value advantages and disadvantages…
Advantages:
- Considers the time value of money.
- Accounts for the risks associated with the project.
- Considers all the expected cash flows incurred during the lifetime of the project, so is a more valid representation of the profitability.
- Consistent with the wealth maximisation of the shareholder principle.
Disadvantages:
- The net present value calculation is sensitive to the estimated cost of capital. This can be difficult to estimate, due to challenging and changing macroeconomic factors, therefore this may sometimes be calculated incorrectly.
Payback period summary…
The length of time it takes to fully recover the initial investment outlay.
If the accepted payback period is lower or equal to the predetermined maximum cut-off period, we can accept the project.
Projects with the shortest payback periods are prioritised.
Payback period advantages and disadvantages…
Advantages:
- This is the most simple calculation for evaluating a project as it just involves cumulative cash inflows. Furthermore, it is very simple to understand as the final value is stated in years.
- It is not dependent on the cost of capital and therefore the risk of an inaccurately calculated discount rate is not applicable.
- It is suitable for use with smaller businesses who’s cash inflows are smaller and sources of funding are limited.
- Useful when cash flow projections are highly uncertain.
Disadvantages:
- Doesn’t have a discount rate and therefore the timeframe doesn’t account for the opportunity cost of the money. There could be an alternative project that is better for the firm.
- Ignores any cash flows after the payback period. This could be an issue if the project completely fails after this time.
- Biassed in favour of short-term projects. This means that it could reject a slightly longer-term project that is much better for the company (i.e. with a positive NPV).
- Requires an arbitrary cut-off point.
Discounted payback period summary…
Used to address the lack of a discount rate in the payback period.
This calculates the time the project will take to recover the initial investment after considering the time value of money.
Utilises a discount rate to work out the present value of any cash inflows.
Discounted payback period advantages and disadvantages…
Advantages:
- This is the most simple calculation for evaluating a project as it just involves cumulative discounted cash inflows. Furthermore, it is very simple to understand as the final value is stated in years.
- It considers a cost of capital and can therefore considers the opportunity cost of capital, ensuring the projects chosen are the most value added.
- It is suitable for use with smaller businesses who’s cash inflows are smaller and sources of funding are limited.
- Useful when cash flow projections are highly uncertain.
Disadvantages:
- The results are now dependent on a calculated opportunity cost of capital, which may be incorrect. This could result in a financial manager choosing a project that isn’t the best for the company.
- Ignores any cash flows after the payback period. This could be an issue if the project completely fails after this time.
- Biassed in favour of short-term projects. This means that it could reject a slightly longer-term project that is much better for the company (i.e. with a positive NPV).
- Requires an arbitrary cut-off point.
Accounting rate of return summary…
Uses accounting profits to assess the profitability of a project.
The corporation will accept the project if the average account rate of return is greater than a predetermined hurdle rate.
The average investment value is equal to the average book value of investments over its lifetime.
Accounting rate of return advantages and disadvantages…
Advantages:
- It is easy to calculate, using just a simple formula.
- It doesn’t require the use of estimated cash inflows, which are estimated and could therefore be more accurate.
- The required information (i.e. accounting profit) is readily available.
Disadvantages:
- Ignores the time value and, therefore, the opportunity cost of money. This means that the project may not be the best for the business after a discount rate is applied.
- Ignores the risk associated with long-term investments, as profits are not absolutely guaranteed.
- Focuses on profits rather than cash flows.
Internal rate of return summary…
This is the discount rate that makes the NPV of an investment equal to zero.
Corporations accept the project if the internal rate of return is greater than a hurdle rate.
Uses linear interpolation / extrapolation to calculate the IRR.
Internal rate of return advantages and disadvantages…
Advantages:
- Considers the time value of money and therefore computes the opportunity cost of any projects a company is implementing.
- Considers all cash flows expected to arise from the project, therefore doesn’t have an arbitrary cut off point.
Disadvantages:
- Ignores the size and term of any projects. Longer projects may have a lower IRR than a smaller project, but generate a higher NPV.
- There can be no IRR or multiple IRRs for projects with non-conventional cash flow patterns.
- Involves a complex calculation, using linear extrapolation, or involves using trial and error which can be computed incorrectly, leading to an inaccurate final answer. This can then lead companies to selecting projects that aren’t necessarily the best.
Capital rationing…
In order to maximise the wealth of shareholders, firms should invest in projects that are value-added. They must engage in capital rationing because financial resources are limited.
Soft rationing: an internal decision to limit the amount of capital that will be used for investment decisions.
Hard rationing: external factors that limit the capital that can be used.
Profitability ratio summary…
Managers should consider how profitable each project is, if financial resources are limited.
Can be used to assess mutually exclusive projects.
Profitability ratio advantages and disadvantages…
Advantages:
- Very simple to calculate, requiring a simple calculation of the NPV + investment outlay / investment outlay.
- This means it yields the same result as using the NPV in the first instance.
Disadvantages:
- Does not consider the scale of any projects and therefore may end up causing a business to select a less profitable investment project.
The net present value always takes precedence over the profitability ratio.
