Explain the theoretical rationale for the NPV approach to investment appraisal and compare the strengths and weaknesses of the NPV approach to two other commonly used approaches.
One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery, etc., in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds.
The main stages in the capital budgeting cycle can be summarised as follows:
Forecasting investment needs.
Identifying project(s) to meet needs.
Appraising the alternatives.
Selecting the best alternatives.
Making the expenditure.
One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised in one of two ways: traditional methods and discounted cash flow techniques.
The Net Present Value (NPV) is a Discounted Cash Flow (DCF) technique that relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment, where opportunity cost is the "calculation of what is sacrificed or foregone as a result of a particular decision". If you receive cash you are likely to save it and put it in the bank. Thus, what a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved.
In other words, it is likely that the business will have borrowed the capital to invest in the project. So, what it foregoes by having to wait for the revenues (from the investment) is the interest paid on the borrowed capital.
Thus, NPV is a technique where cash inflows expected in future years are discounted back to their present value. This is calculated by using a discount rate equivalent to the interest that would have been received on the sums, had the inflows been saved, or the interest that has to be paid by the firm on funds borrowed.
A positive NPV means that the project is worthwhile because the cost of tying up the firm's capital is compensated for by the cash inflows that result. When more than one project is being appraised, the firm should choose the one that produces the highest NPV.
Two other approaches to capital budgeting studied are the Accounting Rate of Return (ARR) and the Payback method. ARR is the average rate of return expressing the profits arising from a project as a percentage of the initial capital cost, where: ARR = (Average annual revenue / Initial capital costs) * 100.
Payback is the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period, where: Payback period = Initial payment / Annual cash inflow.
Payback is often used as an initial screening method in capital budgeting and is popular because of its simplicity. Research over the years has shown that UK firms favour it. This is understandable given how easy it is to calculate. In a business environment of rapid technological change, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential. The investment climate in the UK in particular, demands that investors are rewarded with fast returns. Many profitable opportunities for long-term investment are overlooked because they involve a longer wait for revenues to flow. In the payback method, acceptance is based on cost recovery within a cut-off date where as in NPV it is based on the value of NPV (accept if...
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