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Important announcement
Graded Discussion Board
Financial management (MGT201)
Dear Students!
This is to inform that Graded Discussion Board (GDB) No. 01 opening Date June 01, 2015 for discussion and last date for posting your discussion will be June 03, 2015.
Topic/Area for Discussion
“Capital Budgeting”
This Graded Discussion Board will cover lesson 01 to 14.
Learning Objectives
To improve understanding regarding major criteria of capital budgeting and practical view of NPV and equivalent annuity approach in real life.
Scenario
Sufi Bakers - a growing food processing firm in Pakistan having high market share is planning to invest further in its baking facility to gain more market share. The firm’s finance manager has identified the following two independent proposals accompanied by the related cash flows:
Proposal |
Life (Yrs.) |
Discount Rate |
C_{o} |
C_{1} |
C_{2} |
NPV |
Rs. in Lac |
||||||
A |
2 |
11% |
80 |
52 |
61 |
16.09 |
B |
1 |
72 |
88 |
- |
7.27 |
Requirement
Considering the above information, answer the following:
1) Is the available information is sufficient enough to decide on any proposal” If not, what other information would like to include in the above?
2) Using the given information in the above table only, select the proposal giving appropriate support to your selection?
Note: Necessary calculations must be provided.
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what are the techniques of capital budgeting
Discuss on this passage:
Sufi Bakers - a growing food processing firm in Pakistan having high market share is planning to invest further in its baking facility to gain more market share. The firm’s finance manager has identified the following two independent proposals accompanied by the related cash flows:
Proposal |
Life (Yrs.) |
Discount Rate |
C_{o} |
C_{1} |
C_{2} |
NPV |
Rs. in Lac |
||||||
A |
2 |
11% |
80 |
52 |
61 |
16.09 |
B |
1 |
72 |
88 |
- |
7.27 |
Requirement
Considering the above information, answer the following:
1) Is the available information is sufficient enough to decide on any proposal” If not, what other information would like to include in the above?
2) Using the given information in the above table only, select the proposal giving appropriate support to your selection?
Some of the major techniques used in capital budgeting are as follows: 1. Payback period 2. Accounting Rate of Return method 3. Net present value method 4. Internal Rate of Return Method 5. Profitability index.
The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow.
Payback period = Cash outlay (investment) / Annual cash inflow = C / A
Advantages:
1. A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period.
2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.
Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback period.
The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.
ARR= Average income/Average Investment
Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value cannot be known.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firm’s cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept.
3. It may not give satisfactory answer when the projects being compared involve different amounts of investment.
The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows of an investment. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment, it can be determined by solving the following equation:
Advantages:
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.
5. It is compatible with the firm’s maximising owners’ welfare.
Limitations:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances.
3. It implies that the intermediate cash inflows generated by the project are reinvested at the internal rate unlike at the firm’s cost of capital under NPV method. The latter assumption seems to be more appropriate.
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.
PI = PV cash inflows/Initial cash outlay A,
1. It gives due consideration to the time value of money.
2. It requires more computation than the traditional method but less than the IRR method.
3. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost ratio.
well done .... great work... Now come to the point... of discussion...
LoLzzz
On what grounds we have to justify which proposal is appropriate.
On the bases of NPV and Payback Period.
in this gdb c0 c1 c2 kia hai
peace, samaj to aa bhi gai and solution bana bhi liya.
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