Capital budgeting refers to the process of identifying the most worthy or profitable capital intensive investment of a firm. These projects are long-term aimed at maximizing investor’s wealth. ,(Cunningham,Bazlley,Nikkolai,Simmons,Slaughter,pg357). Limor can use these budgeting techniques before investing in new machinery. He can employ the net present value technique (NPV) that focuses on the expected future cash flows in relations to initial capital investment and other expenses discounted to measure the present value using the cost of capital as the discount factor (Hoque,pg156). The method is preferred because it takes to account the time value of money but also it fails in recognition of qualitative aspect of management. Internal rate of return (IRR) can also be used. IRR ignores the cost of capital and instead establish a discount rate that yield a net present value of zero unlike NPV (Hoque, pg156). This technique is more reliable compared to others techniques of capital budgeting because it ignores the hurdle rate and use a more appropriate rate to discount the future cash flows and also it take to account the time value of money. Just like NPV technique will not help Limor in improving the quality of his products because decision is only based on numerical facts. Limor can also use Payback period technique. This capital budgeting technique determines the minimum period that the investor will take to recover the money invested in a capital intensive project(Go¨tze, Northcott, & Schuster,pg75). The payback period is measured in number of years and thus the shorter the payback period the better is the investment. This method is preferred because of its simplicity but has a number of shortfalls, e.g. It does not take to account the time value of money and also ignore non numerical contribution of management. Finally Limor may evaluate the project using the accounting rate of return (ARR).The technique employ the accounting profit instead of future cash flows to measure the return of an investment in relation to average capital invested. ie.ARR=after tax profit divided by average investment (Hoque, pg158). Average investment is given by sum of initial capital invested and final residual value divided by two. i.e. .Average investment= (initial investment +residual value)/2.
2. For Limor to be able to use NPV technique he need to have all the projected future cash flows from the machines and cost of capital to be invested(hurdle rate) and initial capital outlay(cost of the machines). To benefit from IRR technique Limor needs to have, all the projected future cash flows from the machines, compute a discount rate that will yield zero NPV and initial capital outlay (cost of the machines).If he has to use payback as tool of evaluating his project he needs to know, all the projected future cash flows from the machines and the initial capital outlay (cost of the machines).Finally to use ARR Limor needs to have the after tax profit , initial capital outlay (cost of the machines) and residual value of the machines if any.
3. NPV as tool of capital budgeting is advantageous because it take to account the time value of money and also can be utilized to compare many capital budgeting projects. It shortfall is that it does not recognize qualitative aspects of a project also it relies on hurdle rate while discounting.IRR is considered more superior tool with benefit of considering time value of money, using an arithmetically computed discount rate which is more superior than hurdle rate. However the tool is also limited by its inclusivity of qualitative aspects and is mainly based in arithmetic projections. Payback period on the other hand is preferred due to its simplicity but has many weaknesses ranging from not recognizing time value for money and ignorance of non numerical facts. ARR on the other hand is considered strong because it is based on actual profit however just like payback period it fall short on recognizing time value for money and ignorance of non numerical facts.
4. Capital budgeting processes are employed by both public and private entities in enabling decision making. All governments are involved in these processes before undertaking capital intensive project to know level of social welfare that will be realized from such undertaking. Private entities on the other hands just like Limor are greatly concerned with value maximization thus undertake them before committing form capital. In conclusion this implies that capital budgeting processed are essential all forms of business units for them to avoid falling to liquidity and solvency problems.
Cunningham, B. M., Bazlley, J. D., Kavanagh, M., Nikkolai, L. A., Simmons, S., & Slaughter, G. (2015). Accounting: Information for business decisions.
Go¨tze, U., Northcott, D., & Schuster, P. (2008). Investment appraisal: Methods and models. Berlin: Springer.
Hoque, Z. (2005). Handbook of cost and management accounting. London: Spiramus.
skymucdan answered the question on October 7, 2017 at 08:17