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Describe how net present value is used in the financial decision-making process.
The net present value is one of the widely used capital budgeting methods in making financial decisions. The method is used to evaluate the viability of a project on whether it can make profitable returns. The net present value approach stipulates that investments should be made on the projects with a positive net present value as they are profitable unlike projects that give a negative net present value (Bierman & Smidt, 2012).
Explain the disadvantages of using the payback method.
The payback method used in capital budget decision making has certain drawbacks. One of the limitations of this approach is that it does not take into account the time value of money. The method also ignores the profitability of a given project in preference of the payback period. The payback method has the limitation of neglecting the cash inflows generated after the payback period (Sekhar, 2018). It is also disadvantageous in that it ignores the return on investment of a project.
Compare and contrast the internal rate of return (IRR) method from the net present value method (NPV).
There are fundamental differences just like there are similarities between the IRR and NPV methods of capital budgeting. Both of these methods are similar in that they use the discounted cash flow method to evaluate the viability of a project. They also take into account the time value of money in consideration, besides recognizing the cash flows throughout the lifetime of the investment (Sekhar, 2018). However, while the IRR shows the project viability through a percentage, the NPV indicates the same in monetary units. The NPV is comprehensive in helping make investment decisions while the IRR percentage does not guide the investors on the profit to be made. It is hard to arrive at the discount rate in NPV while the rate of return in IRR is easy to derive.
Explain the effects of sunk costs and opportunity costs in deciding whether to accept a project.
The decision on whether to accept or reject a project is dependent on the future cash inflows and outflows of the investment. Sunk costs are expenses that have been already been incurred on a project and are not recoverable. These costs are ignored in making decisions about a project's viability. Opportunity costs, on the other hand, are the cash flows that are realizable in the future and they are considered in making capital investment decisions.
Review the financial considerations a company should make before investing in a project.
There are several financial considerations that a company ought to consider before investing in any project. One key factor to consider is the financial viability of the project regarding its sustained profitability and return on investment. Then the company should consider the availability of the required investment capital or sources of finance for the project. The company can also consider the financial risks involved in the project due to uncertainties in the market. Then there is the period within which the company would wish to recoup the initial investment on the project (Bierman & Smidt, 2012).
Understand how net working capital, depreciation and interest influence the decision to buy or not to buy.
The decision to buy or not to buy a given item is akin to making capital budgeting decisions which rely on the cash flows of the item. The net working capital affects the cash flows when it increase or decreases after offsetting the current assets against the current liabilities. Depreciation affects the cash flows because it is a non-cash expense. The interest, on the other hand, is used to determine the discounting rate or the rate of return for the said item. All these items influence the capital budgeting decisions on whether to buy or not buy (Blokdyk 2018).
Explain how inflation and interest rates affect the capital budgeting process.
The capital budgeting process employs various discounting methods to assess the viability of a project. The different discounting approaches rely on the rate of return to arrive at a decision on whether to fund the project or not. Inflation and interest rates affect the market rate of return by overstating it. To get an accurate result in this process, decision makers deduct the inflation from the market rate to get the real rate of return that is used in discounting the cash flows (Blokdyk, 2017).
Explain how decision trees are used to value investment alternatives.
The decision trees are used to get the ideal investment decision from a given set of alternatives. The binomial options provided by the decision tree facilitates a complete pricing model that applies discrete probabilities to ascertain the value of each available alternative. It is the expected payoff values in a decision tree that help in determining the value of each investment option.
Bierman, H. & Smidt, S. (2012). The capital budgeting decision: Economic analysis of investment projects. Routledge.
Blokdyk, G. (2017). Capital budgeting decisions: The ultimate step-by-step guide. CreateSpace Independent Publishing Platform.
Blokdyk G. (2018). Capital budgeting decisions a clear and concise reference. Emereo Pty Limited.
Sekhar, C. (2018). Capital budgeting decision methods: Payback period, discounted payback period, average rate of return, net present value, profitability index, IRR and modified IRR. Independently Published.
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