Discussion: There are many methods for determining a capital budget, and most fi
ID: 2733061 • Letter: D
Question
Discussion:
There are many methods for determining a capital budget, and most financial managers agree that the NPV method is the best. This discussion will help you firm up your understanding of the NPV method, as well as the other options for capital budgeting.
Raising capital is an important issue for companies, and there are a number of strategies to do so. Each one has inherent risks and benefits, and it is up to financial managers to make the best decisions for their companies.
1. If you were raising capital for a company, what strategy would you use and why? What are the benefits and risks of the strategy you chose?
Explanation / Answer
Answer
Answer 1
Some of the major techniques used in capital budgeting are as follows: 1. Payback period 2. Accounting Rate of Return method 3. Net present value method 4. Internal Rate of Return Method 5. Profitability index.
1. Payback period:
The payback period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project.
Advantages:
1. A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period.
2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.
Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback period.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profitability of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.
ARR= Average income/Average Investment
Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firm’s cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept.
3. It may not give satisfactory answer when the projects being compared involve different amounts of investment.
4. Internal Rate of Return Method:
The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows of an investment.
Advantages:
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.
5. It is compatible with the firm’s maximising owners’ welfare.
Limitations:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances.
3. It implies that the intermediate cash inflows generated by the project are reinvested at the internal rate unlike at the firm’s cost of capital under NPV method. The latter assumption seems to be more appropriate.
5. Profitability index:
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment.
1. It gives due consideration to the time value of money.
2. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost ratio.
Answer 2
There are various sources of finance such as equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc to raise capital for a company,. These sources are useful in different situations. They are classified based on time period, ownership and control, and their source of generation.
Choosing right source and the right mix of finance is a key challenge. The process of selecting right source of finance for raising capital involves in-depth analysis of each and every source of finance. For analyzing and comparing the sources of finance, it is required to understand all characteristics of the financing sources. There are many characteristics on the basis of which sources of finance are classified.
On the basis of a time period, sources are classified into long term, medium term, and short term. Ownership and control classify sources of finance into owned capital and borrowed capital. Internal sources and external sources are the two sources of generation of capital. All the sources of capital have different characteristics to suit different types of requirements.
Strategy According to time-period
Sources of financing a business are classified based on the time period for which the money is required. Time period is commonly classified into following three:
Long Term Sources of Finance: Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20 years or maybe more depending on other factors. Capital expenditures in fixed assets like plant and machinery, land and building etc of a business are funded using long-term sources of finance. Part of working capital which permanently stays with the business is also financed with long-term sources of finance. Long term financing sources can be in form of any of them:
Medium Term Sources of Finance: Medium term financing means financing for a period of 3 to 5 years. Medium term financing is used generally for two reasons. One, when long-term capital is not available for the time being and second, when deferred revenue expenditures like advertisements are made which are to be written off over a period of 3 to 5 years. Medium term financing sources can in the form of one of them:
Short Term Sources of Finance: Short term financing means financing for a period of less than 1 year. Need for short term finance arises to finance the current assets of a business like an inventory of raw material and finished goods, debtors, minimum cash and bank balance etc. Short term financing is also named as working capital financing. Short term finances are available in the form of:
Strategy according to ownership and control:
Sources of finances are classified based on ownership and control over the business. These two parameters are an important consideration while selecting a source of finance for the business. Whenever company bring in capital, there are two types of costs – one is interest and another is sharing of ownership and control. Some entrepreneurs may not like to dilute their ownership rights in the business and others may believe in sharing the risk.
Owned Capital: Owned capital is also referred as equity capital. It is sourced from promoters of the company or from the general public by issuing new equity shares. Business is started by the promoters by bringing in the required capital for a startup. Owners capital is sourced from following sources:
Further, when the business grows and internal accruals of the company are not enough to satisfy financing requirements, the promoters have a choice of selecting ownership capital or non-ownership capital. certain advantages of equity capital are as follows:
Borrowed Capital: Borrowed capital is the capital arranged from outside sources. These include the following:
In this type of capital, the borrower has a charge on the assets of the business which means the borrower would be paid by selling the assets in case of liquidation. Another feature of borrowed capital is regular payment of fixed interest and repayment of capital. Certain advantages of borrowing capital are as follows:
Strategy according to source of generation:
Internal Sources: Internal source of capital is the capital which is generated internally from the business. Internal sources are as follows:
The internal source has the same characteristics of owned capital. Disadvantages of both equity capital and debt capital are not present in this form of financing. Neither ownership is diluted nor fixed obligation / bankruptcy risk arises.
External Sources: An External source of finance is the capital which is generated from outside the business. Apart from the internal sources finance, all the sources are external sources of capital.
Deciding the right source of finance is a crucial business decision. The wrong source of finance increases the cost of funds which in turn would have a direct impact on the feasibility of project. Improper match of the type of capital with business requirements may go against the smooth functioning of the business.