Question

In an approximately 500-word response, address the following issues/questions: Many businesses around the world still fail because their capital investment decisions are based upon a calculation on the back of an envelope and do not take any of the correct factors into account. Even larger businesses often get this wrong. This is a true sign of poor resource management.

• Do you agree or disagree?

• Discuss the alternative methods of investment appraisal and describe the limitations of these to help justify your arguments.

• How do you think that capital budgeting decisions should ideally be made by different types of organisations?

Answer 1

Capital Investment decisions are very important from a financial viability perspective of the company.

I completely agree that decisions as crucial as capital investment decisions should not be based upon calculations on the back of an envelope and should take correct factors in account. This leads to poor resource management and business failure.

Every capital investment decision should be done while keeping in mind the financial viability, the time period of getting the initial investment back as well as generating return on the capital employed. There are various methods to determine the capital investment appraisal

1. Payback method - This method helps to identify the time frame in which the investment would ideally be recovered i.e. break even. This methods is simple and easy to calculate for people from all backgrounds, even non finance people.
However payback method does not take into consideration the time value of money. The time value of money is one thing which impacts projects of long duration. Thus payback method has its own limitations when taken the case of long duration projects.

2. NPV: Net Present Value
This method takes all the cash flows that would be generated in the project and then discounts them to the present thus considering the time value of money. The discount rate would be WACC (Weighted Average Cost of Capital) of the company under question.
A positive NPV signifies that the project would be profitable. A negative NPV signifies loss.

3. IRR - Internal Rate of return.
In this case the cash flows are discounted not once, but twice. This IRR is then compared to WACC to see if there is additional return generated over and above the WACC.

In reality IRR can sometimes give improper results under some circumstances, thus out of NPV and IRR, NPV is a more acceptable process.

Capital Budgeting decisions should ideally depend on the type of organization i.e. an Airline company already has a lot of fixed costs to deal with, thus they may view the project from how fast the capital deployed can be available. IT companies have less fixed costs, thus they would view it from a different perspective as they would not have so urgent a need to get back the cash and would more focus on generating return on investments.

A company with high WACC may want to understand how IRR would be beneficial for it. and hence use IRR & NPV both to ascertain the viability of the project.