Explain the theoretical rationale for the NPV approach to investment appraisal
and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.
One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
The main stages in the capital budgeting cycle can be summarised as follows:
Forecasting investment needs.
Identifying project(s) to meet needs.
Appraising the alternatives.
Selecting the best alternatives.
Making the expenditure.
Monitoring project(s).
One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised in one of two ways: traditional methods and discounted cash flow techniques.
The Net Present Value (NPV) is a Discounted Cash Flow (DCF) technique that relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment, where opportunity cost is the "calculation of what is sacrificed or foregone as a result of a particular decision".
If you receive cash you are likely to save it and put it in the bank. Thus, what a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved.
In o...
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...he initial costs by the cash flow per year provides the cash-flow payback. It is the length of time required to recover the project's initial capital charges and expenses. The larger the cash-flow payback (i.e., the longer the payback period), the riskier the project. However, the cash-flow payback method neither accounts for the time value of money nor does it credit the income following payoff of the initial costs. In other words, it provides no information about the return rate for the investment made during the project.
No one of the above financial measures is adequate for project prioritisation. Most firms use two or more of these financial measures to prioritise projects. Since economic evaluations are done using spreadsheets, there is no reason not to calculate all these financial measures, and then use the appropriate ones during project prioritisation.
Capital Budgeting encourages managers to accurately manage and control their capital expenditure. By providing powerful reporting and analysis, managers can take control of their budgets.
...eting tool that show the differences between the present value of revenues and the present value of expenses. The project can be profitable when the net present value is positive. In other words, the present value of revenues is greater than the present value of expenses. Profitability index is another tool for evaluating investment projects, which is the ratio of the PV of benefits on the PV of costs. A project can be beneficial if the profitability index is greater than 1. Also, it has the same idea as NPV that In other words, the present value of benefits is greater than the present value of costs. However, these two methods (NPV and Profitability Index) have been used to evaluate the proposal of implementing EHR.
This object is one of the financial goals to invest properly. Marriott used discounted cash flow techniques to evaluate potential investment. It is beneficial because it is considered present time value. Projects which increase shareholder value could be formed with benchmark hurdle rates, the company can ensure a return on projects which results in profitable and competitive advantage.
Capital budgeting is how a firm decides whether it should invest in a project. To determine if a project should be invested in, firms use methods such as net present value and internal rate of return to analyze the projected cash flows. Firms should choose projects that increase its value.
Discounted Cash Flow Method takes the forecast free cash flows during forecasted horizon. Then we estimate the cost of capital (weighted average cost of capital) and estimate continuing value (value after forecast horizon). The future value is discounted to the present value. We than add back cash ($13 Million) and non-current assets and deduct total debt. With the information provided several assumptions had to be made to obtain reasonable values (life period of 30-years, Capital expenditures not to exceed $1 million dollars, depreciation to stay constant at $1.15 Million and a discounted rate of 10%). Based on our analysis, the company has a stand-alone value of $51 Million at the end of fiscal year end 1990 with a net present value of cash flows of $33 million that does not include the cash and non-current assets a cash of and non-current assets.
Discounted cash flow is a valuation technique that discounts projected cash inflows and outflows to evaluate the potential value of an investment. There are three discounted cash flow methods: Net Present Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR). The net present value discounts all cash inflows and outflows at a minimum rate of return, which is usually the cost of capital. The profitability index refers to the ratio of the present value of cash inflow to the present value of cash outflows. The internal rate of return refers to the interest rate that discounts cash inflow projections to the present to ensure that the present value of cash inflows is equivalent to the present value of cash outflows (Brown, 1992).
A company's budget serves as a guideline in planning and committing costs in order to meet tactical and strategic goals. Tactical goals such as providing budgetary costs for daily operations, and strategic objectives that include R&D, production, marketing, and distribution are all part of the budgeting process. Serving as a guideline rather than being set in stone, the budget is a snapshot of manager's "best thinking at the time it is prepared." (Marshall, 2003, p.496) The budget is a method in which to reign-in discretionary spending, and will likely show variances between what costs have been anticipated and what costs are actually incurred.
This is where the cash flow reaches its peak but also at the point of
There is a range of criteria relevant for a decision of financing a new venture. To construct my list for the evaluation of a new company as an opportunity I have selected to refer to t...
Quantitative plans are called budgets. Budgets are prepared to impose cost controls on the activities of an organization (Chenhall, 1986).Budgets are then used to evaluate the performance of the management and budget itself is considered as a standard to evaluate the performance Solomon, 1956). The purpose of the budget is also to implement the strategy of the organization and communicate it to the employees of the organization Rickards (2006). The change in the external environment has led to the change in the budgeting approaches from the initial cash based budgets to the zerio based budgets (Bovaird, 2007).
The expectation of what will come in the form of future revenue in relation to the dollars spent today on the project will determine the viability and profitability of the project or expenditure which is presented before the company. By using the NPV calculation a company can reasonably conclude whether or not to go forward with an investment with cash they have on hand today. The positive of this calculation method and approach is the projected return will give a better idea of the project’s feasibility and probability of coming to fruition. (Gallo,
The purpose of my paper is to discuss the budget process, “make” or “buy” decisions, and nonfinancial performance measures. I will explain what they do and why they are used. They each have a distinct importance and are important for any business. A basic definition of a budget process is “to provide a budget figure for each item” (Schmidt, 2017).
One reason is that many successful investment ventures itself is the outcome of these ‘irrationality’. Risk-taking, which is inevitable in investment, may contribute to the investors’ better performance than others, while with the assistance of proper training, assessment accuracy can be increased(Palich and Ray Bagby, 1995). Also, if without precedent, most of the newly-invented value-maximising approaches or strategy of investment ought to be considered as crude and unthoughtful, but in reality, they are regarded as innovation(Busenitz and Barney, 1997). Furthermore, there are evidence shows that instead of being the hindrance of correct investment decision-making, those biases and heuristics are backed up by probabilistic information. Accurate statistical probability can be evaluated by our inductive reasoning mechanism with a relatively high possibility(Cosmides and Tooby,
The management of cash is essential to the survival of any organization. Managing an organization’s financial operation requires knowledge of the economy and ways to maximize revenue. For any organization to operate on a daily basis adequate cash flow is required. Without cash management the organization will be unable to function because there is no cash readily available in case of inconsistencies in the market. Cash is also needed to keep the cycle of the company’s operations going.
The literature review will include four areas: (a) motivation in investment tendency, (b) emotion in investment tendency, (c) financial literacy in investment tendency, and (d) risk awareness in investment tendency. Individual investment behavior has recently attracted a great deal of attention from researchers in the fields of economics, psychology, and marketing.