Week 4 Discussion Question 1b Introduction Capital budgeting is a critical decision for any financial manager. The need for relevant information has led to numerous studies to help firms make better decisions. These models allocate resources effectively. Early research indicates that methods such as the payback model were commonly used to determine the time required for the firm to recover the cash outlay and generate project returns.
Other models simply utilized the concept of the time value of money. However, newer models are now striving to incorporate additional factors into their analysis that can greatly impact a manager’s decision. Recent research has highlighted the vital importance and often intricate nature of capital budgeting decisions. There are multiple reasons behind the adoption of capital budgeting. Firstly, such decisions necessitate significant financial investments to kickstart a project… Secondly, companies must devise strategies to generate and recoup the funds they initially invested.
Finally, it is essential to have a good sense of timing when using this model in financial decision-making. There are several alternative models commonly used for evaluating capital budgeting projects: the payback method, accounting rate of return, present value, internal rate of return (IRR), modified internal rate of return (MIRR), and real options. However, academics criticize the payback and accounting rate of return models for disregarding the actual size of the investment and its calculation using the concept of Time Value of Money.
The NPV model is different from this method as it discounts the projected income from the project at the firm’s acceptable rate of return, known as the hurdle rate. By comparing the present value of the income to the cost of the project, we can determine the NPV. If the NPV is positive, greater than zero, the investment would benefit the firm. On the other hand, if the NPV is negative, less than zero, the investment would be detrimental to the firm and should be rejected.
In regards to the statement that the “general consensus suggests that, ultimately, the Net Present Value (NPV) method is superior to other capital budgeting methods,” I partially agree. A study conducted by Mao (1970) found that the NPV method was the least popular among capital budgeting practitioners. The study involved sending a questionnaire to companies in various industries such as budgeting, mining, transportation, land development, retailing, and utilities.
The study examined various stages in capital budgeting processes and the methods used to mitigate risk. The findings indicated that firms prioritize the use of the IRR rate of return model when making decisions. To adjust risk, many firms increase their profitability requirement. Defining a project and determining cash flow projections were identified as the most crucial and challenging stages in the process. The preferred method for evaluating all projects is the IRR method or discounting cash flow projects.
When it comes to risk, most firms still use the payback method as a backup. However, some argue that the most superior method is NPV because it shows the expected change in shareholder wealth based on projected cash flows and discount rate. Additionally, when cash flows span a longer period of time, NPV assumes that intermediate term cash flows are reinvested at the capital cost. Importantly, NPV is not affected by multiple changes in cash flow, which is why firms with larger capital budgets tend to favor IRR and NPV.
Multiple decision makers have raised practical concerns about the accuracy of Cash Flow estimations and the decisions made based on these models. The uncertainty surrounding cash flow estimates makes some managers hesitant to incorporate this method into their decision making process, particularly because it involves projecting future outcomes. Consequently, they rely more heavily on near term cash flows. Some managers may already have predetermined preferences for specific projects and manipulate the numbers to achieve their desired outcome. This can cause issues because any flawed results are not due to faulty models but rather inappropriate inputs from the manager. Another issue is the selection of a discount rate, as an incorrectly high rate can result in elevated hurdle rates while a too low rate leads to lower rates.
Cooper advises using an accurate discount rate that reflects the company’s true cost of capital, which is sound financial advice. Thus, it is crucial to consider both best and worst case scenarios when evaluating the optimal decision. If the discount rate considers inflation, decision makers must adjust future cash flows accordingly. It is typical for decision makers to assume that conditions will remain unchanged without a new project, despite the fact that the environment will inevitably change regardless of project implementation.
In order to establish a suitable benchmark for the new project, it is crucial to carefully consider the conditions that will be faced if the project is not executed. This is because the new project will interact with operations and must align with the organization’s goals. Essentially, it needs to encompass all costs and benefits, especially those associated with training, computer expenses, and start-up costs. If proper planning is neglected, the manager may become frugal which would lead to reduced effectiveness and efficiency of the project. In today’s rapidly changing global and high-tech environment, taking on new projects sometimes entails a complete overhaul of the manufacturing environment.
It is crucial for companies to keep up with the fast pace of the competitive world, which is now focused on technical devices and producing cutting-edge results. In order to stay competitive, companies must develop new strategies that prioritize customer satisfaction and efficient service delivery. Therefore, managers need to use methods that will maximize the wealth of shareholders. Commonly accepted practices for addressing these issues include multiattribute decision models and the analytical hierarchy process. These methods have been created to consider “softer” factors in the decision-making process, such as the importance, impact, and probability of various factors. These factors should be viewed by managers as relevant and subjective. In recent years, there has been a shift towards models discussed in previous studies, which incorporate present value techniques. As a result, the payback method has become slightly more popular than the IRR and NPV methods, as it is easier for managers to understand. A recent survey has confirmed that a majority of companies are now using Capital Budgeting Techniques that incorporate the concept of TVM.
References
- Brealey, R. and Myers. S . (1984), Principles of Corporate Finance. 3rd ed. New York: McGraw-Hill. Brown, K. 1978) “The Rate of Return of Selected Investment Projects,” Journal of Finance, Vol. 33 (4). pp. 285-287 Cooper, W. ,Morgan, R. & Redman,G. (2001) Capital budgeting models, theory versus practice [Online].
- Available from: http://www. entrepreneur. com/article/116186585_3. html (accessed: 28 March 2009). Kim, Suk & Farragher, E. (1981) “Current Capital Budgeting Practices,” Management Accounting ,pp. 26-30. Mao, J. (1970) “Survey of Capital Budgeting: Theory and Practice,” Journal of Finance, pp. 349-360
