Week 6 Discussion Question Response

Introduction
Capital budgeting involves the commitment of current funds in long term project or
activities. It is synonymous to investment appraisal and guides in decision making.
Effective investment decision making is vital to business continued existence and
long-term success (Kersyte, 2011). These decisions help to shape an organization’s
future opportunities and build competitive advantage in the business world

Capital Budgeting Evaluations

Payback period
This method of capital budgeting evaluation take into consideration the duration it
will take a project to payback the initial investment made into the project business
(Atrill & McLaney, 2011).  This method of capital budget evaluation is beneficial as it
takes into consideration liquidity and ensures that selection of project that has the
ability to provide back immediate cash. It can also consider very importantly the cash
flow in place or as against profit within the period of the project. However, one of the
limitations of this method is that it does not take into consideration the time value for
money. Payback period is not a measure of profitability and does not seek to
maximize the wealth of shareholders.

Accounting rate of return (ARR)

This method of capital budgeting evaluation takes into consideration profitability of a
project. It is calculated by dividing the average accounting profit of the project by the
average capital invested during the life span of the project business (Atrill &
McLaney, 2011).  It is of the view that the main factor in determining the worth of an
investment is the level of profitability that a project is meant to yield. It does not focus
upon liquidity and cash flows.

Net present value (NPV)

NPV endeavor to determine the present worth of a series of cash flows from a project
that extends into the future. It can be used to compare two projects that are mutually
exclusive. It takes into consideration the time value of money, relevant cash flow and
objective of the business (Atrill & McLaney, 2011). NPV is considered to be most
reliable method because it takes into consideration all the time value for money and
all cash flows for the present and future (Atrill & McLaney, 2011).
Internal rate of return (IRR)
IRR is the discount rate or factor for, which the NPV equals zero i.e. the compound
rate of return that is obtained from a series of cash flows. This rate equates the present
worth of the cash inflows of a project’s to the present worth of its outflows (Atrill &
McLaney, 2011).  It is beneficial as it takes into consideration time value of money
and over the entire life of a project. However, it does not take into consideration the
relative size of investment and it involves complicated calculations

Case Study of Investment in Bahamas Island

Assumption of the Case study
i) There are two projects that are mutually exclusive
ii) They both have the same level of riskiness
iii) The rate of return is 20%
 iv) Project A investment cost is 1000 and expected to yield an annual cash flow of
1000
v) Project B investment cost is 10000 and expected to yield an annual cash flow
of 4000
IRR
Using IRR to evaluate the investment, it shows that project A will yield a return of
100% and project B will yield a return of 40%. This thus indicates that project A is
more worthwhile than B because it has a higher IRR.
Payback period
Using payback period to evaluate the investment, Project A will payback the
investment in the first year while Project be will payback the investment in 2.5 years.
Payback period= Initial Capital out lay/ Cash inflow (Atrill & McLaney, 2011).
Project A = 1000/1000 = 1 years
Project B = 10000/ 4000= 2.5 years
This thus indicate that Project A takes a shorter time to payback the investment and it
therefore preferable to Project B.
ARR
Using ARR to evaluate the investment, it can be calculated thus:
ARR= Average annual operating profit x 100 (Atrill & McLaney, 2011)
Average investment to earn that profit
Project A = 1000/1000 x 100= 100%
Project B = 4000/10000 x 100= 40%
Since both of the investment exceeds 20% which is the target rate, the higher will be
selected. Thus Project A is more preferable.

NPV
Using NPV to evaluate the investment with the discount rate of 20%, after fives the
NPV of the two projects are shown below.

Year Discount rate Project A Project B NPV A NPV B

20% £ £ £ £
0 1 -1000 -10000 -1000 -10000
1 0.83 1000 4000 830 3320
2 0.695 1000 4000 695 2780
3 0.5718 1000 4000 571.8 2287.2
4 0.4746 1000 4000 474.6 1898.4
5 0.3939 1000 4000 393.9 1575.6
NPV 1965.3 1861

After five years the PV of project A will be £2965 and for project B will be
£11861.They are both greater than the initial investment. Both Projects A and B are
worthwhile, since each of them has a positive NPV. But project A is preferred to B
because it has the higher NPV of £1965.3.

Factors to consider in choosing an investment

i. The objective for investing
ii. The time when the money invested in needed back
iii. Level and type of risk involve in the investment
iv. How quickly can one turn the investment into liquidity or profitability
Conclusion
I agree with assessment after using alternative evaluations for the capital budgeting
like the NPV, Payback period and ARR. All of them thus indicate that Project A is
more beneficial.

Reference List
Atrill, P. & McLaney, E. (2011) Finance and accounting for managers. Laureate
Online Education custom ed. Harlow, UK: Pearson Custom Publishing.

Kersyte (2011) ‘Capital budgeting process: theoretical aspects’ Economics and

Management 16 pp.1130-1134 [Online]. Available from:
http://www.ktu.lt/lt/mokslas/zurnalai/ekovad/16/1822-6515-2011-1130.pdf
(Accessed: 03 April 2014).