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 and so on, 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: 1. Forecasting investment needs.
2. Identifying project(s) to meet needs.
3. Appraising the alternatives.
4. Selecting the best alternatives.
5. Making the expenditure.
6. Monitoring project(s).
Looking at investment appraisal involves us in stage 3 and 4 of this cycle. We can classify capital expenditure projects into four broad categories: • Maintenance - replacing old or obsolete assets for example. • Profitability - quality, productivity or location improvement for example. • Expansion - new products, markets and so on.
• Indirect - social and welfare facilities.
Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project's aims. So investment appraisal may help to find the cheapest way to provide a new staff restaurant, even though such a project may be unlikely to earn profits for the company. Investment appraisal methods:
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 one of two ways: traditional methods and discounted cash flow techniques. Traditional methods include the Average Rate of Return (ARR) and the Payback method; discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return techniques.
This is literally 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. Payback is often used as an initial screening method. Payback period = Initial payment / Annual cash inflow
So, if £4 million is invested with the aim of earning £500 000 per year (net cash earnings), the payback period is calculated thus: P = £4 000 000 / £500 000 = 8 years
This all looks fairly easy! But what if the project has more uneven cash inflows? Then we need to work out the payback period on the cumulative cash flow over the duration of the project as a whole. Payback with uneven cash flows:
Of course, in the real world, investment projects by business organisations don't yield even cash flows. Have a look at the following project's cash flows (with an initial investment in year 0 of £4 000): |Year |Cash flow |Cumulative cash flow | | |(£ 000) |(£ 000) | |0 |(4000) |(4000) | |1 |750 |(3250) | |2 |750 |(2500) | |3 |900 |(1600) | |4 |1000 |(600) | |5 |600 |Zero | |6 |400 |400 |
The payback period is precisely 5 years.
The shorter the payback period, the better the investment, under the payback method. We can appreciate the problems of this method when we consider appraising several projects alongside each other. |Year |
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