Capital Budgeting and Decision Making (Coursework Sample)

CAPITAL BUDGETING AND DECISION MAKING Introduction Companies are faced with challenges on whether or which project / investment is suitable to make. The pinpointing of the investment is easy and straightforward, but the decision on how profitable it is and the time span is an issue, (Bierman & Smidt, 2012). The management is faced with the challenge in making a sound decision for the investment to create going concern of an organization. The decision made is not only for the company but the public interest at large. Note this; the capital budgeting is very crucial and important to the shareholder and general public. Decisions made by the management determine the direction the company is going, and for any unprofitable decision, management is held accountable, (Brealey, Myers & Marcus, 1995). Just like in our case here, EEC is faced with a challenge on whether to invest in the supplier or not. Their decision will involve determining the expected rate of return that such an investment can generate. This is important because it will enable EEC to develop long term decision goals and also formulate their operation strategy. Additionally, the capital budgeting decision making will enable the firm to take a proper direction on whether to seek a new investment project or retain the existing one. Similarly on the capital decision to be made by EEC, will involve consideration of the capital budgeting tools which include; internal rate of return (IRR), net present value (NPV) and payback period (PBP), (Wilkes, 2012). Note this, knowing financial and investment decision is paramount to a profitable investment. Overview of capital budgeting decision tools Net present value (NPV) This is the universal tool or technique for determining whether the project is outstanding or not, profitable or not. It calculates the difference between cash outflow "initial investment," and cash inflow, that is cash generated on investing in a project, (Žižlavský, 2014). It’s suitable because it takes into the account the time value of money. It uses the discounted rate of return in calculating the expected cash flow to future date. It recommends, if the future cash inflow exceeds the initial investment, then the project is viable, but if the initial outlay is more than future expected cash flow, then the project is rejected, (Noreen, Brewer & Garrison, 2014).  In regards to President of EEC to decide on whether to invest in supplier, he or she can accept to undertake the project if the NPV is positive and reject if the NPV is negative. Please note, for the independent project, accept investment with positive net present value (NPV) and for the mutually exclusive project, accept the project with the highest positive NPV. Profitability index – Modification of Net Present Value It's another technique for evaluating the worthiness of an investment. It is also known as a value investment ratio and works together with net present value. The technique is useful for ranking project base on the value created per unit outlay. Profitability index, in other words, is the adjustment of net present value and it is the ratio between the net present value (NPV) and the initial outlay/investment and is one of the techniques used to gauge the project efficiency. The technique is useful because it takes into consideration the time value of money just like NPV and IRR. It is also useful since it factors out all the cash flows and also considers the risk which may be associated with the investment. Decision Rule for Profitability Index Consider or accept the project if the profitability ratio is greater than one. This shows the profitability nature of the investment, but if the profitability ratio is less than one, abandon or reject the project. Less value than one show the expected cash flow will be less than the initial investment. Note, this method is an adjustment of net present value, and so the EEC should take it into consideration on valuation decision, whether to invest in the purchase the supplier or not As earlier mentioned, capital budgeting provides an organization with a decision on whether to strongly invest in the short run or long term investments. It is not only a scientific decision-making method but also the true and tested procedure for developing financial decision. President of EEC should take it into an account on making a conclusive decision on whether to accept or to abandon the project. The decision should not only be tired around the three techniques, but that is also, internal rate of return (IRR), net present value (NPV) and payback period. Internal Rate of Return Relatively to NPV, this is the discounted rate of return preferably used to determine the amount an investor expects to generate from a specific investment. To be noted, internal rate of return equates net present value to zero (IRR = NPV = 0), that is, it occurs where the project is break even, (Osborne, 2010). On decision making, the IRR is compared with the Cost of Capital, and if the IRR is higher than the cost of capital, then the project is accepted. The higher the difference the worth is the investment. The advantage of the internal rate of return is that it also considers the time value of money. In our case here, the president of EEC should only consider the purchasing a supplier if the IRR is higher than the cost of financing, (Magni, 2010). Note, if the internal rate of return is lower than the cost of financing, then the purchase decision is rejected. Payback Period (PBP) It is the simplest budgeting tool in determining how long the project will take in paying back its initial investment. It’s probably useful when expected cash inflow of a project is uniform, (Irani, 2010). Though been simple, the method does not consider the time value of money. It assumes the value of shilling today will be the same tomorrow, which is not the case. To be noted, the technique is suitable for the small business with normal uniform cash flow and also for the mutually exclusive projects with conflicting net present value, (Kolltveit, Karlsen & Grønhaug, 2007). Therefore, in regards to our decision on purchasing the supplier, the President of EEC should consider the time the expected cash flow will pay the initial investment. The shorter the period, the suitable the investment is. Alternatively, if the period for the cash flow to pay initial outlay is long and uncertain, then reject the project. Notable Decision made by EEC on whether to invest or not should also entirely consider the economic and political factors such as inflation, prices, political stability, and many others. In this case, due diligence should be done to analyze whether the purchasing plan will have any impact on the organization and whether it will be suitable for the long run. The three techniques mentioned above should be a research factor for the EEC team to decide on whether to accept the project or to reject. EEC president should be well informed on the decision to take, whether having of benefit to the shareholder or not. The three techniques mentioned are the drivers to financial investment decision making. Capital budgeting decision is all about where to allocate fund and whether the project chosen guarantees a continuous flow of the income. Also to note, when considering the project, time value of money is very useful. It assumes that money in hand today will not be the same tomorrow. This means the management should be very keen on deciding which technique to employ in order to minimize the unforeseen risks. Relative to our scenario, the EEC should with much concern the time value of money before drawing any decision to purchase the supplier. This will enable the company to plan adequately in the future and be able to adapt to any economic changes. Part II Based on the calculation, EEC should acquire the supplier. This is because there is a positive gain on the investment. According to NPV, the project will register a positive value of $ 658,100 at the end of the tenth year. On making the investment decision, EEC should consider using NPV technique since it considers the time value of money. NPV guarantees to save at least $ 658,100 at the end of the tenth year. Payback period would be the least technique to consider when deciding to invest in purchasing supplier since it does not consider the time value of money. It also does not consider cash flow after the initial investment recovery and therefore the method is considered inappropriate. Note, from our calculation the initial investment recovery is at forth year, and after that the payback period method does not consider cash flow generated thereafter. Alternatively, EEC should not consider using internal rate of return to make a sound decision on purchasing the supplier since the rate of return is lower than the cos...