Capital budgeting techniques are the financial tools used to assess whether investment decisions are viable. Some of the budgeting methodologies used in business valuation are the net present value (NPV), the adjusted present value (APV), the internal rate of return (IRR), payback period, profitability index, amongst others. This paper delves into some of these techniques: the NPV, the APV, the IRR, and the payback period. The definitions of these techniques are provided. The strengths and limitations of these techniques are also provided. The ways in which the APV differs from the are also elaborated.
Business Valuation Techniques
Business valuation techniques are important in financial management as they provide companies with the criterion to evaluate various investments’ viability (Hasan, 2013) . The various capital budgeting techniques expose the risks and uncertainties that might be encountered, thus helping managers control their investments. Examples of business valuation methodologies are internal rate of return, the present worth method, also referred to as the net present value (NPV), payback period, adjusted present value (APV), modified return rate, and the profitability index (Bennouna et al., 2010; Brijlal & Quesada, 2009 ). All the techniques have both strengths and weaknesses.
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The NPV and APV and their Differences
When using the NPV method, the time value of future cash inflows is taken into consideration. Future cash flows have less value today due to uncertainties, such as inflation (Gallo, 2014). An investment is profitable if the discounted cash flows exceed the asset’s initial cost. An investment is deemed not worthy if the discounted cash flows are less than the total initial costs. When using this method and two or more investment proposals are mutually exclusive, the investment proposal with a higher NPV is chosen (Kalhoefer, 2010). The major strength of the net present value is that it accounts for future cash flows reduced value in the present day (Gallo, 2014). However, its weakness is that it is majorly based on assumptions (Žižlavský, 2014) . A company could experience unforeseen problems after the investment, making future cash inflows unattainable and the profit margins calculations incorrect.
A popular alternative to the NPV is the adjusted present value (APV). The APV brings together the NPV, the debt financing fees such as the interest taxation shields, including interest tax shields, debt issuance costs, distress costs, and subsidies (Dastgir et al., 2010; Kountzakis et al., 2017) . In APV, it is assumed that the project risk is equivalent to the average risks arising from other investments in a company. Also, corporate taxes are assumed to be the only market imperfection for every debt. Interest tax shields are focused on while the effects brought about by debt costs and financial distress are ignored. While using the APV method, all debt is assumed to be perpetual. The APV is most valuable when evaluating investment proposals having fixed debt scheduling as the side effects of financing the projects can be easily accommodated. The project is broken down into its most basic components that help provide clear information needed to control the project’s execution
The NPV and APV are differentiated in that the APV considers benefits accrued by raising debts. The cost of equity is taken as the discounting rate when computing APV. On the other hand, the weighted average cost of capital (WACC) is taken as the discount rate when computing the NPV (Žižlavský, 2014) . To calculate NPV, the cash flow is calculated from the project assets and discounted using WACC as the discount rate. To calculate APV, NPV has to be calculated considering the option of entirely financing the project at the expense of equity. Using the APV approach is less prone to errors, and it has fewer restrictive assumptions, thus highly recommended.
Other Popular Valuation Models
The payback method is a popular capital budgeting methodology and is deemed by most people as one of the least complicated techniques. A company comes up with a time plan on how to pay off an asset. The initial cost of the asset and cash flow to be generated each year are considered. The shorter the payback period, the faster a company can recover the cost of purchase or initial investment into a project. According to Sullivan et al. (2014) and Lumen Learning (n.d.), a shorter payback period is indicative of lesser risks and uncertainties. A significant weakness of this method is that a project’s subsequent performance is not considered making long-term projects seem less profitable than short-term projects (Žižlavský, 2014) .
The second valuation technique considered in this discussion is the internal rate of return (IRR). IRR is a profitability assessment tool. The discounting rate, which gives an NPV of zero for cash inflows and outflows, is referred to as the IRR (Mellichamp, 2017). It compares the returns made by the asset to the company and project’s financing costs. A project is deemed profitable when the rate of return exceeds the costs incurred to fund the project. Currency amounts are not given much importance as compared to percentage results. The IRR technique utilizes the cash flows discounting approach.
References
Bennouna, K., Meredith, G. G., & Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada. Management decision .
Brijlal, P., & Quesada, L. (2009). The use of capital budgeting techniques in businesses: A perspective from the Western Cape. Journal of Applied Business Research (JABR) , 25 (4). https://doi.org/10.19030/jabr.v25i4.1015
Dastgir, M., Khodadadi, V., & Ghayed, M. (2010). Cash flows valuation using capital cash flow method comparing it with free cash flow method and adjusted present value method in companies listed on Tehran stock exchange. Business Intelligence Journal , 3 (2), 45-58.
Hasan, M. (2013). Capital budgeting techniques used by small manufacturing companies. Journal of Service Science and Management , 06 (01), 38-45. https://doi.org/10.4236/jssm.2013.61005
Kalhoefer, C. (2010). Ranking of mutually exclusive investment projects–how cash flow differences can solve the ranking problem. Investment Management and Financial Innovations , (7, Iss. 2), 81-86.
Kountzakis, C., Migliavacca, A., Tibiletti, L., & Uberti, M. (2017). When does financial leverage create economic value? International Mathematical Forum , 12 , 553-558. https://doi.org/10.12988/imf.2017.7334
Lumen Learning. The Payback Method | Boundless Finance . Courses.lumenlearning.com. Retrieved 14 November 2020, from https://courses.lumenlearning.com/boundless-finance/chapter/the-payback-method/ .
Mellichamp, D. (2017). Internal rate of return: Good and bad features, and a new way of interpreting the historic measure. Computers & Chemical Engineering , 106 , 396-406. https://doi.org/10.1016/j.compchemeng.2017.06.005
Sullivan, W., Wicks, E., & Koelling, C. (2014). Engineering economy (16th ed.). Pearson.
Žižlavský, O. (2014). Net present value approach: Method for economic assessment of innovation projects. Procedia - Social and Behavioral Sciences , 156 , 506-512. https://doi.org/10.1016/j.sbspro.2014.11.230
