1a. Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions and calculate the NPV for a capital project.
The net present value presents superior investment judgments when compared to other methods since it (a) utilizes the discounted cash flow variation technique that represents the money’s time value, plus (b) directly measures how much capital project is expected to enhance an organization’s dollar value (Abor, 2017) . The net present value is, therefore, in line with the objective of optimizing the fortune of the stakeholders.
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b. What are the benefits and drawbacks of IRR, payback period and ARR ?
The advantage of payback period is simple to utilize and comprehend; it is suitable for the project with the quickest return since it maximizes liquidity and minimizes risks. The drawbacks include that it ignores the money’s time value, the cash flows timing, and the cash flows once the payback period expires (Abor, 2017) . ARR is comparable and simple to understand. The disadvantages include it ignores cash flows timing, money’s time value, and it is based on profits that are affected by accounting policies. IRR is advantageous because the outcome is easier to compare and understand, utilizes cash flow and considers money’s time value (Abor, 2017) . The disadvantages of IRR is that it may overstate the return rates, is not appropriate for exclusive projects, does not consider the cost of capital, and it may produce multiple confusing values.
2. Suppose a firm uses a single discount rate to compute the NPV of all its potential capital budgeting projects…. can you explain why such a firm would tend to become riskier over time?
The organization is picking ventures whose Internal Rate of Return is bigger than the single discount rate (Mellichamp, 2017) . The greater the IRR in ventures, the riskier they are. If the firm is choosing only such projects, over time, it will become riskier.
3. Describe how net present value is used in the financial decision-making process.
The NPV method is utilized in assessing the desirability of projects and investment. Each investment has cash inflows and cash outflows (Abor, 2017) . NPV is the present values (PVs) total plus the outflows and inflows. When the outflows are less than the inflows and are discounted to the PVs, then the NPV is positive, and the investment is valuable to the investor and vice versa. When NPV is 0, the investment does not provide any change in value. As such, an investment should be made when NPV is positive and is the highest among the available investments choices.
4. Explain the disadvantages of using the payback method.
In the payback method, the net incremental cash flow is not attuned to the money’s time value (Abor, 2017) . For instance, a net incremental cash inflow of $10,000 in the third investment year is considered to possess similar purchasing power or value as a $10,000 cash outflow that represented the original investment completed three years before. After the payback period, the incremental cash flow received are ignored (Abor, 2017) . For instance, project A and B may have the same payback periods but cash inflow from A might decline steadily after the payback period ends while B might increase. As such, payback period may provide limitations when used for ranking potential investments.
5. Compare and contrast the internal rate of return (IRR) method from the net present value method (NPV).
Both TRR and NPV are employed in the capital expenditures’ evaluation process. While IRR is the rate at which the sum of discounted cash inflow equates discounted cash flow, NPV is the total of all the cash flows’ present values (both negative and positive) of a project (Mellichamp, 2017) . IRR is expressed as a percentage while NPV is expressed in absolute values. IRR represents the point of no profits no loss NPV represents the surplus from the project. IRR does not help in making decisions since the percentage does not give details of how much money will be made while NPV provides an outcome that represents the foundation for an investment decision. When NPV is utilized, the presumed return of reinvestment rate of the instant cash flows is the organization's cost of capital while in IRR method; it is the internal rate of return. NPV encounters discount rate issues while IRR does not since it derives the rate of return from underlying cash flows.
6. Explain the effects of sunk costs and opportunity costs in deciding whether to accept a project
Sunk costs are the money and time that has been spent on investment or project and cannot be reclaimed (Larson & Gray, 2013) . When deciding on investment or project, the sunk costs should not be factored in and should be treated as already lost and make the decision based on opportunities and costs. On the other hand, opportunity costs need to be considered when deciding on investment as they do not necessarily involve any cash outflows to be considered because they mirror the unavoidable profit (Larson & Gray, 2013) .
7. Review the financial considerations a company should make before investing in a project.
The company’s goal when making capital investment decisions is to maximize the shareholder’s wealth by yielding profits and acquiring assets (Abor, 2017) . As such, the company’s responsibility is to establish the capital investment projects with a positive cash flow even when the resources are limited. The company should consider calculating the AAR and payback period, the NPV, and IRR (Abor, 2017) . It is also important to determine the accurate tax data, consider the cash flow budget, fiscal incentives, market forecasts, the competitor’s strategy, and the opportunities created by the project.
8. Understand how net working capital, depreciation and interest influence the decision to buy or not to buy
Depreciation should be considered when calculating the cash flow related to any project. While it is not a cash expense, it has a direct effect on cash flow, reduces the organization's net income as well as its tax bill (Collier, 2015). The working capital is the total sum of the assets minus the liabilities and is directly related to the company’s cash flow hence should be considered in making business decisions.
9. Explain how inflation and interest rates affect the capital budgeting process
Inflation influences the analyses in capital budgeting because the market capital cost is not a complete illustration of the actual cost of fund-borrowing (Collier, 2015) . Inflation affects cash flows and discount rates. Inflation reduces the value of the real rate of return and also increases the costs of goods including labor, equipment, and building materials which makes some projects unfeasible (Collier, 2015) . The impacts of inflation can be eliminated from analysis of capital budgeting by determining the actual rate of return and utilizing it in the calculation of cash flow. Since inflation reduces the value of the assets, it should be compensated for adequately.
10. Review the types of assumptions used in sensitivity and scenario analysis.
Sensitivity analysis helps determine what happens to the project if the estimates and assumptions are unreliable. It entails changing the assumptions in a calculation to determine how the finances of the projects are impacted. Thus, the managers are well prepared for any odds regarding the project’s outcome (Borgonovo & Plischke, 2016) . The assumptions are primarily different variables used by the revising the beliefs about the profitability of a project and determining what happens in different scenarios. Scenario analysis examines and established the probable event that can happen in future by considering the feasible outcomes. It is mostly used in companies to determine the best scenario.
11. Describe how the options to expand or abandon a project are integrated into the capital budgeting process.
Real options is not a requirement but a right to obtain expected cash flows’ gross present value by making an irretrievable investment before the opportunities become unavailable. Real option places a value on the capability to make an investment now and make additional ones in future if the investment is successful (expansion) ( Mbabazize & Daniel, 2014). It can also value the capacity to abandon the venture is it is unproductive (abandon alternative). It also has the timing option whereby value is placed on weight and learning.
12. Explain how decision trees are used to value investment alternatives.
If one has two investment options, a decision tree may be used to outline the critical elements and help in visualizing a choice (Abor, 2017) . The two projects are paralleled, and the expected outcomes of each one of them are determined. The trees lay out the choices and consequences so that the two alternatives can be challenged and results explained using simple mathematics. Once the value of each course of action is determined, the best investment alternative is established.
References
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting. In Entrepreneurial Finance for MSMEs (pp. 293-320). Springer International Publishing.
Borgonovo, E., & Plischke, E. (2016). Sensitivity analysis: a review of recent advances. European Journal of Operational Research , 248 (3), 869-887.
Collier, P. M. (2015). Accounting for managers: Interpreting accounting information for decision-making . John Wiley & Sons.
Larson, E. W., & Gray, C. (2013). Project Management: The Managerial Process with MS Project . McGraw-Hill.
Mbabazize, P. M., & Daniel, T. (2014). Capital Budgeting Practices In Developing Countries: A Case Of Rwanda. Journal of Finance vol. 2 No 3 Hal. 34 , 38 .
Mellichamp, D. A. (2017). The internal rate of return: Good and bad features, and a new way of interpreting the historic measure. Computers & Chemical Engineering , 106 , 396-406.
