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Financial Management

Introduction to Financial Management

The capital budget contains a number of important projects for the company. Almost every part of the capital budgeting process, including the purchase of land or fixed assets, for instance trucks or new machinery can be involved. In general, companies need, or at least recommend, projects that increase profits and therefore improve the wealth of shareholders.

However, other factors which are specific for the company as well as the project have an influence on the rate of return which is considered acceptable or inacceptable (Kengatharan, 2016).

The process of capital budgeting is through which the value of a potential investment project is determined by investors.

Payback (PB), internal return rate (IRR) and net present value (NPV) are three of the most common ways to select projects. Profitability index (PI) is also measuring the same thing.

However, the rate of returns that are acceptable or inacceptable are affected by other factors specific to the company and the project (Gupta, 2017). For example, social and organizational projects are often implemented with the wish to increase the goodwill of businesses and to help their communities, rather than on the basis of incomes.

The capital budgeting mechanism is used by creditors to assess the worth of a future investment project. On the basis of payback period (simple payback period), ’Replace’ project is acceptable, because it has lowest time period to recover the invested money. Renovate project recovered its investment in 3 years (3,000,000 each year), but Replace project has capacity to recover within one and half year.

Calculation of Measures (Requirement 1 to 4)

On the basis of NPV Renovate project has highest net present value, it should be accepted for investment.

NPV = Present value of cash flows – Initial investment

Considering internal rate of return (IRR), project with higher rate of return would be acceptable, and here project Replace is acceptable due to higher rate of return.

Calculations = point of discount rate where NPV is equal to zero.

IRR = [Cash flows/ (1+r)I] – Initial investment

On the basis of Profitability index project with higher profitability index would be accepted, here approximately same value of profitability index, but little bit higher of Replace project.

Profitability Index = PV of future cash flows / initial investment

Year

Cashflows Renovate

Cashflows Replace

0

-9000000

-2400000

1

3000000

2000000

2

3000000

800000

3

3000000

200000

4

3000000

200000

5

3000000

200000

Rate of return

15%

Project Renovate

 

0

1

2

3

4

5

CF (Renovate)

(9,000,000)

3,000,000

3,000,000

3,000,000

3,000,000

3,000,000

Recoverable balance

 

(6,000,000)

(3,000,000)

0

   

Payback period

     

 3 years

   

PV (@0.15)

(9,000,000)

2,608,696

2,268,431

1,972,549

1,715,260

1,715,260

NPV

1,280,195

         

IRR

19.85771%

         

Profitability Index

$1.1173

         

Project Replace

 

0

1

2

3

4

5

CF (Replace)

(2,400,000)

2,000,000

800,000

200,000

200,000

200,000

Recoverable balance

 

(400,000)

(0.5)

200,000

   

Payback period

   

 1.5 years

     

PV (@0.15)

(2,400,000)

1,739,130

604,915

131,503

114,351

114,351

NPV

304,250

         

IRR

23.69%

         

Profitability Index

$1.1205

         

 

Note: all calculation have been done using formulas in MS excel

Conflicting Recommendation

We noted that almost every problem with a net present value (NPV) can persist and therefore is considered to be the best way to analyze, assess and select large-scale investment projects. Caution is often important in cash flow calculations, as NPV can be deceptive if cash flow projections are inaccurate.

A minor problem with NPV is that the discount rate for cash inflow and outflow is similar. We realize that the interest rates on the loans are different from the interest rate of deposits.

The profitability index is the ratio of cash flow to the initial cash outflow. It displays the level of the return on the expenditure in the context of the discounted values of cash flow (De Souza and Lunkes, 2016).

The recurrence of this method is related to the disadvantages. A project can have a single profit margin with a large difference in different investments and a complete return on the dollar. NPV is excellent in this regard.

The IRR does not recognize size of investment and does not involve dollar amounts in the proposal (Su et al., 2018). The difference between two projects with the same IRR can not be determined, but the big difference is the dollar return. NPV talks very clearly on the other side and this argument is also not missed.

The IRR regards cash flow discounts and investment returns at the same level. If the IRR for a very good project is 35%, investing on the market at this level is not possible. In the meantime, NPV is of the view that the debt and risk amount is near and not completely feasible.

  • It does not consider cash flow after PBP.
  • Ignore the time value of money.

The second deficiency still lies in the expanded version of PBP, usually known as the rebate period. The main distinction is that capital balance is free of income management, while cash flow after PBP is not included.

NPV Intersection and Cross Over

Crossover rates are capital costs where two projects have the same net present value (NPV) or where the NPV profiles meet. This calculation is often used for the analyzes of the capital budget as it provides insight into the capital cost (Puwanenthiren et al., 2018), if two projects that are mutually exclusive are the same. When cost of capital is greater than crossover rate, the goals of the project are not impacted.

The crossover rate determines which of the two potential projects is most profitable. In particular, the calculation provides an understanding of the performance of different projects and weighs their potential revenue for risk (Musah et al., 2018).

To calculate IRR, the same formula is used as NPV. However, the NPV has been replaced with zero and the IRR replaces the exemption (Malenko, 2019). Furthermore, unlike NPV, IRR carries the notion that a project's positive cash flow is reinvested in IRR rather than the cost of capital. The formula directly acknowledges that the positive cash flow is returned to the IRR.

Cross over point of this project lies above 20%, at this cost of capital NPV for each project is equal. We may say that at this stage NPV profiles intersect each other.

On the basis of this analysis we can say that Replace project is favorable because NPV of this project still above the line and Renovate likely to decrease the net present value of the project.

  • On the basis of NPV profile analysis, if the cost of capital is 15%, Renovate project would be acceptable because it has higher net present value as compare to Replace project.
  • If the cost of capital increased up to 25%, both projects goes into loss and negative NPV but Replace project has low loss as compare to Renovate.

In budget analysis, crossover rate capital is helpful in advising investment firms of capital costs where two joint international ventures are equally successful. If the capital expense of the business is greater than the crossover point, the value of the joint ventures varies, i.e., if Project Renovate is favored above this the crossover point at a discounted rate of approximately 20%, Project Replace has low pace of decreasing net present value.

Conclusion on Financial Management

Discussion on capital budgeting technique shows that NPV is the best project evaluation technique, other techniques have drawbacks more significant than NPV. Regarding both of these projects there is big difference of investment. Renovate have 9 million investment and 3 million return per year, but as compare to this project, ‘Replace’ have only 2.4 million of investment even smaller than first return of Renovate project. Normally this is the advantage of getting higher NPV than Replace. But here a project has only less than 1/3 of cost which project is Replace have approximately same profitability index that means Renovate must be higher rate of return and profitability index due to higher amount of investment. Observing this point, ‘Renovate’ has not given the advantage of big investment. Amount could be invested in other small projects of higher investment.

References for Financial Management

 DE-Souza, P. & Lunkes, R. J. 2016. Capital budgeting practices by large Brazilian companies. Contaduría y Administración, 61, 514-534.

Gupta, D. 2017. Capital budgeting decisions and the firm’s size. International Journal of Economic Behavior and Organization, 4, 45.

Kengatharan, L. 2016. Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3, 15-38.

Malenko, A. 2019. Optimal dynamic capital budgeting. The Review of Economic Studies, 86, 1747-1778.

Musah, A., GAKPETOR, E. D. & POMAA, P. 2018. Financial management practices, firm growth and profitability of small and medium scale enterprises (SMEs). Information Management and Business Review, 10, 25-37.

Puwanenthiren, P., Thirunavukarasu, V. & Sathasivam, B. 2018. An Empirical Analysis on Capital Budgeting Models, Uncertainty Tools, Cost of Capital and Firm Performance: A Comparison between Australia and Sri Lanka. European Journal of Applied Business and Management, 4.

Su, S.-H., Lee, H.-L., Chou, J.-J., Yeh, J.-Y. & Thi, M. H. V. 2018. Application and effects of capital budgeting among the manufacturing companies in Vietnam. International Journal of Organizational Innovation (Online), 10, 111-120.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Accounting and Finance Assignment Help

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