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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...
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…
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.
Transfer pricing
Transfer pricing refers to pricing of internal transactions, for example when goods are sold by one company to another company in the same group, or possibly transfers between divisions. When undertaking capital budgeting, the potential benefits and risks associated with transfer pricing will need to be considered. A project may be viable due to the economies which can be gained from in-house, or in group supply. Likewise, the potential benefits may also be limited in terms of national regulation and the way in which transfer pricing is controlled. Transfer pricing will impact on the costs and potential profits that are assessed when examining potential investments or projects. The security of the
1 0.107 0.107 1.788005 4.37% 7.24% D 20 Lev 1.2925 0.120475 0.11038 1.653411 4.05% 7.22% D 50 Lev 1.87 0.1609 0.16045 -0.1731 -0.44% 7.05% 5. The only project that is unacceptable is Project D. At the 50% leverage level. This has a negative NPV. The other projects at each leverage level all have positive net present values. The following graph shows the NPVs for the different projects: 6. My objective in making this decision is to maximize firm value. The projects are mutually exclusive. I would use NPV as the main
Finance One of the biggest differences between new capital projects and renewal/replacement projects is that the variables are less known. The cash flow for the next few years is subject to a higher degree of uncertainty, but so too is the risk profile for the project. The latter is especially important when the project is in an entirely new business, and the firm has very little concrete information to go on.
However, with budgeting, management can easily see how much money is available for projects and what the most pressing issues of the company are. Without the budget, the company is doomed as it is unable to account for its cash flow and revenue streams (Sullivan, 2003). Also, various financial models can be used to aid management. These tools can include sensitivity analysis and regression analysis. Sensitivity analysis in particular is
"MIRR: A better measure." Business Horizons. 51(4), 321-329. Cited in: http://econpapers.repec.org/article/eeebushor/v_3a51_3ay_3a2008_3ai_3a4_3ap_3a321-329.htm McClure, B. (n.d.). "Taking Stock of Discounted Cash Flow." Investopedia. Cited in: http://www.investopedia.com/articles/03/011403.asp?partner=answers "Modified Internal Rate of Return." (2009). Cited in: http://www.thinkanddone.com/finance/mirr.html Parrino, R, & D. Kidwell. (2009). Fundamentals of Corporate Finance. (Vol. 1, Ed.). Wiley Custom Solutions. Smart, S. And WL. Megginson. (2008). Corporate Finance. Thompson Learning. Sullivan, A. And S. Sheffrin. (2003). Economics: Principles in Action. Prentice-Hall. The IRR is the rate of return that makes the
The NPV method is when the company will discount all possible income received from an investment, to where it is in line with their projected minimum rate of return (hurdle rate). At which point, managers will be able to see if the present value will have a positive or negative return for the organization in the future. Those projects that can provide positive present values will more than likely
NPV There are a few conceivable reasons why decision-making methods other than net present value have been used by practitioners. The appeal of payback period is that it is easy to understand, for example. For small businesses especially, if there is no finance professional, the concepts in net present value might be too complicated, so payback period is used for simplicity. Another technique is IRR, which is no more or less