Capital Budgeting and Investment Decisions

Published: 2019-09-03 00:30:00
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Capital budgeting is an essential practice that is usually carried out by businesses when assessing which investments or projects it is to engage in. It is a process that involves the planning of either replacing machinery or equipment or adding a physical plant or equipment for the long run whereby the business plans its expenditures on assets whose returns are expected to exceed a year. This paper analyzes and presents the quantitative analysis methods. We will use an example of a company XYZ, which wants to make an investment. The reason we are evaluating this investment, is to offer a good advice and recommend the management on which investment will be valuable thus investing in it. By acquiring a printing machine, the XYZ Company is planning on expanding the growth and capacity of the company. Through this acquisition, the company expects to increase value within the company. Therefore, the management wants to assess the investments in which it wants to engage in. Hereby, it is to assess the two machines which it has to decide upon to replace the existing one. The management is to follow a certain procedure and carry out calculations to evaluate the machines separately. Each machine is considered as a project. Once each machine is evaluated, the results will be computed and finally the recommendations given to the management on which machine to purchase.

The process begins at the evaluation of these projects. The value determination for each printing machines evaluation is used in this process. The project evaluation is carried out through developing incremental cash flows, calculating terminal cash flows and calculating the discount rates. The revenue and costs that are relevant in each project are calculated and presented. The investment which is proposed by the management is to bring incremental and valuable changes within the company hence calling for an incremental analysis.

The evaluation of a project involves numerous performances of incremental cash flows. Incremental cash flows of each investment will be presented. The methodology to be applied is based on the following assumption;

The cash flows of each machine will be assessed

The process will not include the previous costs.

The future and current costs are to be associated with the cash flows.

MACRS will be applied which will include a schedule of 5 years of depreciation which will include 6th year depreciation

The net sale price of the old machine which is current will be compared to the other machines.

Inflation is not to be incorporated so as to ensure consistency.

The cash flows applied are; initial investment, incremental cash inflows and the terminal cash flows. After the application of the cash flows, then comes the summarization of the cash flows that are relevant. The cash flows on annual basis, throughout the project are presented from the initial investment to the incorporation of the terminal cash flow of each machine. After the presentation, the initial investment is subtracted from the cumulative cash flows to obtain the difference of each project. However, these cash flows are based on the data and estimations given. Therefore they are forecasts hence making it is essential to discount the cash flows so as to convert these forecasts to the present days value. In evaluation, it is essential to consider the risk premium and opportunity cost. The Capital Asset Pricing Model (CAPM) is a formula that is used to approximate the total cost of the capital. In the process of capital budgeting and the valuation of a project, the capital is the major input. Therefore, Capital Asset Pricing Model formula is used in calculating the cost of capital required. The formula applied is:

CAPM: r = rf + B x (rm-rf) whereby; rf = rate of return which is risk free rm = the markets risk (rm-rf) = the risk premium, B= markets volatility

The techniques of capital budgeting have been in use for a long time. This was because companies were looking for ways to cope with the numerous uncertainties. In our case study the techniques applied are; Net present Value (NPV), Payback period (PB), and internal rate of return (IRR).

NPV- is the difference acquired by subtracting the amount initially invested and the present value of the cash flows to be generated by the investment in the future. The present value is attained by discounting the cash flows at a given rate of return. However, there are some disagreements about the validity of NPV. This is because its calculations are based on the CAPM. The CAPM method provides to the technique in this case NPV, the input. This was identified as a flaw when it came to defining the real value of the risk premium of a market (Jagannathan and Meler, 2002). Hence the managers are warned to be careful when using NPV and this is because when a positive NPV is acquired when assessing a project, it does not mean that it is an opportunity. NVP becomes more appropriate when applied on large projects of big companies which have limited time to come up with a new project. However it is argued that, in most cases the managers do not use this technique correctly and this is because, they lack the adequate knowledge required to apply these techniques when it came to valuating new investments. However, through this technique, the NPV of machine A was higher.

PB- is a technique that involves calculating the period required of the project to attain the amount that was invested initially. It is measured in periods of time which are years. The payback period of the projects is calculated by the following formula;

PB= (the number of the year the last amount of negative cash was invested) + (the negative amount of cash that was invested in that year/ the operating cash flow of the following year)

After calculations, the payback period of A was 2.78 years and of B was 2.26 years. The PB offers a technique of choosing one project over the other. However, one is advised not to depend on this method only since it does have a few flaws. Therefore, it would be better to combine it with other methods when using it. In addition to this, the management should have a threshold which it desires, to be the benchmark when it compares the payback period of the new machines. This will help to make a decision on which machine is to be approved.is

IRR- is a technique that discounts the cash flows. It is the average returns earned annually throughout the lifespan of an investment. The IRR and the NPV are used in the evaluation that requires the comparison of two or more projects. Here machine B has a high IRR.

After the calculating the cash flows, the results are compared. The results of the calculations are summarized and concluded. The results will determine which press will be proposed to the management. The results computed showed machine B was the best choice to invest in. This is because in all the techniques, the results of machine B were better. However, before making the decision, the rationing of the capital should be done. This determines the highest benefit the company gets with the capital it has then. The profitability index is used in this case. The profitability index is a ratio that is specified and is used to compare the present value of the future cash flows to the amount of money invested in a given project. Hence when the profitability indexes of each machine were acquired, Machine B was more preferable.

The introduction and measurement of the risk factor is important in capital budgeting. This is because uncertainties delay the commitment of the investment. Uncertainties are in relation to the cash inflows that are to be expected in the future. This is because the amount invested is not known. Scenario analysis is usually carried out to prevent risks and come up with various outcomes for the project. To measure the risk factor we use two techniques; Decision Tree which is used to determine the course which the actions will take that will be optimum in a situation where there are numerous alternatives whose outcomes are unknown. The decision tree as per its name is depicted or drawn as cluster of tree branches. It displays various decisions that could be undertaken in addition to the interplays and interrelationships among the various alternatives, the decisions taken and the outcomes that could be obtained in the end. The other technique used to measure the risk factor is the Risk Adjusted Discount Rate (RADR) which is earned so as to compensate the investors risk. The RADR and the risk calculated are positively related. Therefore if the risk is high, the RADR will be high too. The RADR tends to be subjective hence specifying it becomes difficult. In our case to make it less difficult, the CAPM will be incorporated in the RADR formula. Below is the formula used in calculating RADR:

kpress A= Rf + [ b pressA (kf-Rf)]

The higher the uncertainties of the forecasted cash flows of a project, the larger the discount rate.

There are two methods used to calculate RADR. The first method is based on the systematic risk and in our case, it has been incorporated with the CAPM and the second method, is flexible but subjective since it is based on ones evaluations. After calculating RADR, it was confirmed machine B to be a better project.

The capital raising comes after calculating the risk factor. There are two ways of raising capital so to finance a project. These are: financing through equity and financing through debt. These are the most common ways of raising finances for most companies to fund the projects which they would like to undertake. Each of these ways has its pros and cons hence making the company to carefully assess and evaluate the decisions they make when they want to invest. The two ways of financing have risks and benefits. Therefore, it is the responsibility of the management to check any impacts that these methods of financing would bring and incorporate these impacts in the managements strategy. Therefore, to reduce the amount of risks and exploit the advantages of both methods of financing, the company can use both methods to raise capital. Equity and debt are imperfect substitutes. They can demonstrate either a negative or positive relation. This depends on the companys operations nature. Therefore, these two are complementary sources of financing. Before raising the capital to be invested, the structure of capital needs to be assessed. The study of the sources of finance used by a company to fund investments is called capital structure. This is in relation to the mix of debt and equity in a company and the decision-making when it comes to maintaining the balance. On making a decision by the company to make alterations to its structure of capital, this leads to information on the opportunities of potential projects being revealed to the shareholders. This is because any changes to the companys capital results to a direct impact on the position of a shareholder, financially. By altering the capital structure, this results to the redistribution of the companys wealth. Finally, the structure of the capital reflects the mentality and characteristics of the company which affect the decisions that are strategic.

The share of the company is valuated in the end. The Dividend Discount Model is applied when evaluating the share of the company. This involves the forecasting of dividends to be acquired in future so as to value the equity. This will show the effect the new printing machine is expected to impact on the shareholders. The dividend discount model values the prices of a stock through the prediction of dividends and discounts them to the present value. Therefore, if the obtained value from DDM is higher compared to the trades of the stocks then the stock is undervalued. This is to determine how much the shareholders will g...

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