The paper is set out in four sections. The first section explains the use of NPV and IRR. The second section looks at different types of risk which may impact on capital budgeting, such as exchange rate risks and political risk. The third section discusses capital structure. The last section explains the connection between the cash conversion cycle and working capital.
Accounting
Capital Accounting and Budgeting Questions
NPV
When a firm has different potential projects or investments, they will want to assess their options to ensure they make the best choice. However, comparing different types of projects or investments can be difficult, especially if the projects have different terms to maturity and/or different risk profiles. A useful tool is that of net present value (NPV). Net present value allows different types of project to be compared on a like for like basis.
The net present value calculation takes all of the forecast future net cash flows of a project (the revenue less all the costs), and then discounts them into today's value. The discounting allows the firm to assess what the value of the future cash flows will be in today's money. The rate of discount applied will usually be the cost of capital for the firm, but where there is a high level of risk, this may also be adjusted to allow for a risk premium (Arnold, 2012). The calculation will result in a final figure, which is the total of the net discounted cash flow for each year, less the initial investment. By presenting a single figure to be assessed there is an easy basis for comparison. It is worth noting this process is biased towards sort term results, as the compounding of the discount rate has a greater impact on longer term results (Arnold, 2012). It may also be difficult where there are projects that are significantly different in terms of size, as it only gives a final monetary value, and no indication of efficiency (Arnold, 2012).
An alternate approach may be the calculation of the internal rate of return (IRR). This is based on an NPV calculation, but instead of giving a single monetary figure, the result in the expected internal rate of return that each project will provide for the firm, allowing for the assessment to be based on the return that the firm requires (Atrill, 2011). However, it is worth noting that while the NPV result does not require an assumption regarding reinvestment of funds, with the IRR there is an underlying assumption that the funds realized will be reinvested at the same rate; an assumption which may not always be accurate or even viable (Atrill, 2011).
Part 2 - Capital Budgeting
Capital budgeting may be impacted by a number of risks, some of these can be considered individually, but it is worth noting they will often manifest in an interdependent manner.
Exchange rate risk
Where investments are made in a difficult country, or loans are taken out in a different state, there may be exposure to fluctuations in currency exchange rates (Atrill, 2011). Changes will occur in even the most stable floating rates, which can impact on the value of the investment and/or loan, and the amount they will receive or have to pay back. For example, if an investment is undertaken in Europe by a U.S. firm the revenue they will generate and profit that can be repatriated will be in Euros and need to be exchanged into dollars. If the project was supported by a loan taken out in the U.S. In dollars, any adverse movements may impact on the affordability of the loan and the amount. Conversely, if a loan is taken out at a lower interest rate in a foreign currency, adverse exchange rate movements may increase the amount that needs to be repaid when assessed in dollars. Therefore, when budging, firms have to allow for potential exchange rate movements (Atrill, 2011).
Political risk
Political risk manifest in a number of ways, they may be in the policies and laws that a government enacts, political instability and even aspects such as competition regulations. These will all impact on the potential level of risk associated with an investment. When undertaking capital budgeting, for a project to be viable, where there is an additional risk it is necessary for there to be a risk premium to justify taking that additional risk. The introduction of different types of policies, regulation or laws by government, may impact on the overall value of an investment, and in some cases may be severely detrimental. For example, in some countries there may be a risk of nationalization which the company may lose a significant amount of its investment (Mintzberg et al., 2008). Likewise, the amount of value in investment may create, especially if it is targeting markets, will be impacted by the competitive conditions, which in turn influenced significantly by government policies and attitudes.
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