Net present value analysis usisng capital budgeting techniques

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Net present value analysis usisng capital budgeting techniques

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Registration No: H00173156

Course Code: C38FN

Lecturer: Dr. Welcome Sibanda

Tutor: Ms. Rehnuma Shahid

Word Count: 2726

Table of Contents

Section A - Introduction.............................................................................................. 3

Section B 3 Methods of Capital Budgeting...............................................................4

Net Present Value (NPV).......................................................................................... 4

Payback Period (PBP)............................................................................................... 6

Internal rate of Return (IRR).................................................................................... 7

Section C Criticism, Pros & Cons..............................................................................9

Criticism.................................................................................................................. 9

Pros & Cons of NPV.................................................................................................. 9

Pros & Cons of PBP................................................................................................ 11

Pros & Cons of IRR................................................................................................. 12

Section D Conclusion............................................................................................. 13

Section E References............................................................................................. 14

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appraisal

Section A - Introduction

Net Present Value is one of the characteristics of speculation evaluation or capital budgeting.

Most enormous businesses make decision based on inventing activities that requires capital

budgeting technique. The most vital decision making for this technique is the projects NPV. This

helps an investor to analyze whether the firm should invest in a new equipment or project, which

shows if it is worth it to pump in the cash and it indeed results in fair long-term benefit.

Therefore the shareholders select those projects that will earn maximum future return from the

investment (Dayananda, 2002).

NPV is one of the aspects of capital budgeting and the basic concept in most of the course books.

Most focus will be given to NPV as it helps to analyze investment activity in a company which

determines if one should make invest in the activities of the company leading to a profit. The

basic rule for this determination is: if an NPV of a particular project is negative then you reject it

and accept the projects with a positive NPV (Ross, 1995).

This essay describes the importance of NPV, Payback Period (PBP) and Internal Rate of Return

(IRR) with the help of calculations and examples. Section A- will talk about introduction and the

roots of NPV. Section B will be divided into 3 parts, explaining one method for each part. In

section C- the best method chosen will be criticized and the Pros and Cons for NPV against the

respective methods. At last, section D and E will contain Conclusion and References.

Page 3 of 17

Net Present Value (NPV)

The net present value is described as the sum of the present value of all the cash inflows and

outflows of a specific project which is discounted at the rate rational with the projects risk

i +

C

t

(1+r )

investment of a project, C is the cash flow, r is the discount rate and t is the time period. The

formula changes depending on the number of years for the cash outflow, that is

i+

NPV =

C1

C2

Ct

+

1

2

( 1+ r ) ( 1+ r )

( 1+r )t

NPV provides accurate information as the cash inflows are added to the negative initial

investment, divided by the discount rate which gives an exact value for a project and helps the

investor to decide if one should invest in the project based on the NPV, only if it is greater than

zero. With the help of it, maximum shareholder wealth can be achieved. Therefore, it is good, as

it is simple to use and it can be easily compared. There is no need for pitch research. It is the

easiest method compared to IRR and PBP. NPV takes into consideration the periodic value of

money and likewise it is the analysis that focuses on profitability over an investment made as a

main objective.

Example of NPV Assume that a manufacturing company manufactures wooden doors. They

want to expand and think about investing in 2 equipments, equipment A costs $10000 and

Page 4 of 17

equipment B costs $10000. Both equipments are mutually exclusive. The discount rate is 15%

and the cash flows are as follows:-

Equipment A

Year

0 (Initial Investment)

1

2

3

4

Cash flows

$-10000

$6000

$4000

$10500

$8500

Equipment B

Year

0 (Initial Investment)

1

2

3

4

Cash flows

$-10000

$6000

$400

$4000

$600

Solution

Equipment A =

Equipment B =

10000+

6000

4000 10500 8500

+

+

+

=$ 10005

1

( 1.15 ) ( 1.15 )2 ( 1.15 )3 ( 1.15 )4

10000+

6000

400

4000

600

+

+

+

=$1507

1

2

3

( 1.15 ) ( 1.15 ) ( 1.15 ) ( 1.15 )4

Equipment A gives a Positive NPV and Equipment B gives a negative NPV. The basic decision

rule suggests that NPV, which results in a positive value, should be selected. As a result

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decision is to be taken between mutually exclusive equipment then the criteria to be followed is

to choose either 1 equipment or none but certainly both equipment cannot be chosen.

Page 6 of 17

Payback period is the time period that is required to retrieve the investment made for a project.

Unlike NPV it does not take into consideration the present value of money streams. It is an

important determination whether to accept the project or reject it because longer payback periods

are not preferably acceptable by any business owner as faster returns is what they look forward

to. It is the easiest approach of capital budgeting, very simple to understand and investment with

undersized payback period increases the liquidity position of the business so it is positively good

(Adams, 2003). PBP can be calculated with the formula: Payback period =

Net annual cash flow

However it can also be calculated with the help of cumulative like shown in the example below

using the same question as for the NPV.

Example of PBP

Equipment A

Year

Cash flow

Cumulative

0

1

$-10000

$6000

$-10000

$6000

$4000

$10000

$10500

$18500

$8500

$29000

Equipment B

Year

Cash flow

Cumulative

0

1

2

$-10000

$6000

$400

$-10000

$6000

$6400

Page 7 of 17

$4000

$10400

$600

$11000

The cumulative shows the negative initial investment made and keeps adding up the cash inflows

which add up in a straight line one after another. Once the cumulative chart is made we evaluate

which equipment gives a faster payback and hence choose the year which restores the investment

at the earliest. In this example we select equipment A as it restores the initial investment in the

2nd year which is $10000, compared to equipment B which recovers its investment in the 3rd year

that is $10400. It can be classified that a short payback period decreases the danger of misfortune

brought about by changing monetary conditions so a payback by the 2nd year is fairly very good.

Internal rate of Return (IRR)

IRR is the discount rate that is frequently used in capital budgeting, which makes the NPV of all

money streams from a specific investment equal to zero. It is utilized to assess the appeal of a

business activity (Adams, 2003). Usually greater the internal rate of return for a project, the

better it is to accept the project.

The discount rate in IRR plays an analytical role as a greater discount rate can result in either

zero or a NPV value less than zero, but we choose the one with a value that is equal to zero and

get that percentage which is used to calculate the NPV as the IRR (Adams 2003). The example

below will compute how to get the IRR with the help of excel, using the matching question used

for NPV.

Page 8 of 17

Example of IRR

Equipment A

Year

0 (Initial Investment)

1

2

3

4

Cash flows

$-10000

$6000

$4000

$10500

$8500

Equipment B

Year

0 (Initial Investment)

1

2

3

4

Cash flows

$-10000

$6000

$400

$4000

$600

Solution

Equipment A =

Equipment B =

10000+

6000

4000 10500 8500

+

+

+

=$ 10005

1

( 1.15 ) ( 1.15 )2 ( 1.15 )3 ( 1.15 )4

10000+

6000

400

4000

600

+

+

+

=$1507

1

2

3

( 1.15 ) ( 1.15 ) ( 1.15 ) ( 1.15 )4

To make the above NPV zero or nearest to the zero we have to try using a different discount rate

that can result to a zero, it is done by the following:

Equipment A =

Equipment B =

10000+

6000

4000 10500 8500

+

+

+

=$ 0

1

( 1.53 ) ( 1.53 )2 ( 1.53 )3 ( 1.53 )4

using 53.78%

10000+

6000

400

4000

600

+

+

+

=$ 0

1

2

3

( 1.05 ) ( 1.05 ) ( 1.05 ) ( 1.05 )4

using 5.15%

Page 9 of 17

The IRR for each equipment is 53.78% and 5.15%. These values are calculated using excel

spreadsheet and it can be evaluated that Equipment A gives a greater IRR, i.e. 53.78 when

compared to equipment B that gives an IRR of 5.15%. So equipment A will be chosen as the

final IRR.

Criticism

NPV is by far the best method correlated to PBP and IRR. Firstly, when NPV is compared to

PBP it is the most beneficial as it takes into account the time value of money invested as well as

the cash flows till the end of a projects life whereas PBP evaluates the period of years until a

particular investment is recovered through repayments and ignores the cash flows after the

investment is recovered. Taking NPV against IRR into consideration, IRR method disregards the

monetary value of money and it does not consider economies of scale.

It is impossible to differentiate two projects with the same IRR and so a big difference occurs in

the investment value return however NPV proves values in exact figures as well as take time

factor into account. Furthermore, the pros and cons for each method will describe the above in

detail.

Pros & Cons of NPV

Pros- NPV majorly considers the time value of money which helps in keeping

in mind as the cost of capital, i.e. the amount of capital to be required in

investing in an organization, the varying interest rates and the opportunity

costs of investment. This method is likely to be used for projects that are

Page 10 of 17

expected to last long. When the net present value of a firm is calculated it

gives an assumption that the value of money is higher than received at a

later note. For example, the value of a dollar earned today would be greater

than the value of it received a year later and thus is describes the concept of

time value of money.

This measure also helps in realizing the risks involved with the cash flow to

be done in the future. Strength of this measure is that if analyzed properly it

provides accurate information about the projects future value. The final

output makes it easy to interpret how the expected return will vary, if the

project is well accepted. The npv is accurate in reflecting the amount of

income that the project would be able to produce at a predicted rate of

return. It states the progress of a project, i.e. how a project will start how far

it will generate the required income and how efficient it will be in the future.

Cons- The ranking investments estimated by the npv do no compare the absolute levels of the

particular investments made. The npv does not consider the profits and losses incurred by the

firm but it rather focuses on the cash flows that take place. The percentage of discount that is

done in the net present value is sometimes difficult to determine depending on the varying

interest rates. The problem in the net present value method appears when it considers the capital

to be unlimited and which in turn causes a fault in the capital rationing.

If the required resources are not enough the researcher has to analyze the net present value as

well as the investment he is making in each of the projects that are taken. The npv requires a

proper research to be done as to know what amount of the finance is needed in the investing. If

Page 11 of 17

the net present value analysis appears too defective it may result in wrong decisions of selecting

the particular projects. The net present value is helpful mainly in comparing the different projects

taken at the same time it does not completely rely on the opportunity cost.

If a firm decides on which investment to take under consideration based on the NPV, there may

be chances of discovering new options that offer a high NPV. The investors do not make quick

decisions in choosing the option that has the highest NPV instead they look for more comfortable

options available.

Pros & Cons of PBP

Pros- The financial analysts prefer the PBP for various reasons. When the

firms evaluate the capital projects they select employees in different fields

and backgrounds. By using the PBP method the evaluation is reduced to a

simple number of years which are easy to calculate and it is considered to be

an easily understood concept. Companies that have limited cash should be

capable of recognizing projects that provide the fastest return on the

invested amount so that the firm can recover whatever investment it had

made.

The pbp method is of great help to the financial managers of an organization

as it helps making quick evaluations that have a small investment. The small

projects usually do not require too many employees or detailed economic

Page 12 of 17

analysis. Managers often use the PBP method for initially evaluating the

projects.

Cons- Irregular cash flows are to be expected from a project with a major amount of return not

occurring until the future. However a project may have an average rate of return but still wont

be able to fulfill the minimum time period provided by the company. The cash inflows from a

project are not considered by the payback method as they may occur after the initial investment

has been recovered. The PBP method majorly relies on the short term profits, which results in

loosing better projects.

Pros & Cons of IRR

Pros- The internal rate of return method is a very clear concept and is easy

to conceptualize. It helps the analysts and the financial managers of a firm to

understand its opportunity cost. In case the IRR exceeds the given rate, then

the project provides the financial funds if needed. However if the investment

rate is predicted to be below the IRR, then the investment would be of no use

to the firms value. The IRR method due to its clear structure is used by

many organizations to show their respective portfolios.

This method is also very popular because of it uncomplicated nature. The

NPV, IRR and PBP methods are the most commonly used in considering any

investment. The outputs of these measures are mostly included in the

analysis that are made in favor of the firm which in turn make the

managements decision making process easier when its the time to decide

whether to start a project or make a future investment. A major strength of

Page 13 of 17

this method is that it does not require a person to have advanced math skills,

i.e. it is comparatively easier to calculate and does not require professional

skills.

Cons- The IRR must assume the rate of discount or the cost of capital that is needed but it is

not possible at all times therefore making it as one of the key weakness of this method. The cost

of capital and the discount rate do not stay stable as they may change on a yearly basis with the

change in the market conditions. It mostly changes on a year to year period of time. The financial

analysts no matter how much research they do, it is likely not possible to measure the accurate

future rate of return.

It is sometimes possible that this method is not applicable because sometimes there is no singular

rate of return or multiple IRR are required for a project and in some of the cases the irr has to be

adjusted in accordance with the firms capital. As a result of poor assumptions it makes the

managements job difficult in making the required decisions. When the cash flow signs are

shown to vary in different years the output would be no IRR or multiple IRR. This method

mostly focuses only the projected cash flows that are brought into the business by a capital

investment and does not pay much attention towards the potentential future costs which are

likely to affect the future profits made by the organization.

The IRR allows the analyst to compute the future cash flows but at the same time it makes a false

assumption that the cash flows which are considered could be reinvested at the same rate as the

IRR. However the assumptions made are sometimes not applicable because the opportunities

turn out to be higher than expected.

Page 14 of 17

Section D Conclusion

To conclude with, this essay described how NPV is a better method for

investment appraisal in comparison to PBP and IRR. More stress was given on

NPV since it more accurate and reliable based on the time value and cash

flows it takes into consideration. Based on the contents and the structure of

this essay, it is critically discussed how each method is important and how to

make a choice built on the examples used. The discount rates used in NPV

are different from IRR as the whole point of IRR is to make the NPV value zero

which would result in a different discount rate. Moreover, it is proved that

NPV is the best method out of all as its advantages are more beneficial as

compared to the other 2 methods and the disadvantages of NPV are less

effective to investment rate of return.

Page 15 of 17

Section E References

Besley, S. and Brigham, E. (2008). Principles of Finance. 4th ed. Cengage Learning, pp.548550.

Brigham, E. and Ehrnhardt, M. (2013). Financial Mangement:Theory&Practise. 14th ed.

Cengage Learning, pp.25-28.

Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P. (2002). Capital

Budgeting:Financial Appraisal of Investment Projects. Cambridge University Press.

Megginson, W. and Smart, S. (2008). Introduction to Coporate Finance. Cengage Leraning

EMEA, p.261.

Moyer, C., McGuigan, J., Rao, R. and Kretlow, W. (2011). Contemporary Financial

Management. 12th ed. Cengage Learning, pp.325-328.

Horne, J. V. Wachowicz, J. (2005). Fundamentals of Financial Management. Williams

Publishing House.

Damodaran, A. (2002). Investment Valuation. Tools and Techniques for Determinin the Value of

Any Assets. New York, John Wiley & Sons.

Brealey, R. A, Mayers S.C., Marcus A.J. (2001). Fundamentals of Corporate Finance. 3rd

edition. New Jersey: The McGraw-Hill Companies.

Graham JR, Harvey CR (2001). The theory and practice of corporate finance: evidence from the

field. J. Finance, pp187-188.

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