Term Paper on "Capital Budgeting Forecasting Is Important in Modern"

Term Paper 4 pages (1757 words) Sources: 3 Style: APA

[EXCERPT] . . . .

Capital Budgeting

Forecasting is important in modern business, moreso now that globalization is a fact and markets fluctuate more rapidly. It is, in fact, the lifeblood of the business, needed to fund working capital to enable it to run effectively. Expenses and investments must be made against delays and uncertain sales levels. The business must make cash flow forecasts to assess the level of cash shortfall in the future, hence the necessity for good cash flow management. Furthermore, investments are based on the ability of the business to generate free cash flows as the investor's reward to the business for taking a risk. Predicted sales levels and the business' cash generation capability are the factors investors consider in making decisions. The forces, which affect or determine demand, include the proposition or fulfilling of an existing need, pricing, macro-environmental trends, competition, seasonal characteristics, substitutes and the market. The aim of sales forecasting is to arrive at widely credible revenue figures. It is not an exact science but a combination of fact-based analysis and subjective judgment. The endeavor helps enhance the entrepreneur's awareness of some key drivers of revenue growth in his or her business, produce a plausible business plan and prepare him or her in answering a potential investor's questions on the market opportunities and marketability of his or her business. However, despite the importance of forecasting, there is no set methodology that is applicable in every capital budgeting situation (Parrino, et.al., 2009).

Capital budgeting defined as the planning process used to identify and determine if an organization's long-term investment strategy (new machinery, products, R&D, etc.) is fiscally sound, therefore worth time, investment and energy. It is a budget for major capital expenditures (Sullivan, et.al., 2003, p. 375). Numerous formal methodologies are used in capital budgeting, each method using incremental cash flow from each unique project. One dichotomy is that often accounting techniques (earnings, etc.) are used for this process (rate of return, return on investment), while most economists see this as too simplistic and an improper use of the data (Dayananda, et.al., 2008; Ansari, 2000). There are three major methods used in capital budgeting, each with their own specific set of strengths and weaknesses: Net Present Value (NPV), Internal Rate of Return (IRR), and Modified Internal Rate of Return (MIRR).

Net Present Value: Net Present Value, otherwise known as NPV, is an accounting term used in capital budgeting where the present value of net cash inflow is subtracted from the present value of cash outflows. Then this value is compared with projected profit ratios for the project in the future. In other words, NPV is useful, particularly to investors, because it compares the value of a dollar today vs. The value of that same dollar in the future, after taking inflation and return into account. NPV is also often used in capital budgeting by firms (Ansari, 2000).

To calculate NPV, the discount rate or cost of capital, or the required rate of return, that is the return required for the project to be an attractive and profitable investment, the length of the project in years and the amount required to initiate the project must be compared with the projected net cash flows to be received throughout the life of the project, with these ratios today. If the present and future cash outflows are likely to be greater than present and future inflows, a negative number must be calculated for that net cash flow. Thus, the NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows. This relationship is expressed by the following formula, whereby:* CFt = the cash flow at time t and * r = the cost of capital. The total present value of a project's expected future cash flows must be enough to satisfy the initial cost to make the investment attractive. If the NPV of a prospective project is positive, then it should be accepted. However, if it is negative, then the project probably should be rejected because cash flows are negative. In other words, according to the commensurate principle that the future value of money, unless it is accruing interest, is usually less than the held value at present (Berkovitch, 2004).

Internal Rate of Return: IRR is also known as discount cash flow rate or return or rate of return, sometimes in the banking industry the effective interest rate. The use of the word "internal" in the title refers to the principal that the calculation does not incorporate any economic environmental factors ("Internal Rate of Return," 2009).

Essentially, because the IRR is more of a rate quantity, it is typically more of an indication of the efficiency, or yield, of an investment. This contrasts with NPV, which is an indicator of the value, or magnitude, of an investment. An investment, then, is considered to be positive if its IRR is greater than a pre-established minimum acceptable rate; if the investment has an IRR that exceeds cost, it adds profit to the organization ("Investment Decisions -- Capital Budgeting," n.d.). The IRR is calculated by using a formula that describes the relationship between time, cash flow, and net present value.

Modified Internal Rate of Return: As the name implies, the MIRR is a modification of the IRR, and ranks project efficiency with the present worth ratio (NPV/Discounted Negative Cash Flow), and is, in many finance textbooks, the optimal way to measure investments and strategically develop capital budgeting modules (Brealey, 2008).

One problem with IRR is that, by its very nature, assumes profits (or positive cash flow) are invested at the same, or very similar, rate of return of the project that generated the profit itself -- clearly unrealistic in a variably evolving marketplace. MIRR then, adds up the negative cash flows after discounting them to zero, adds the positive cash flow after factoring the proceeds of reinvestment, and calculates the rate of return of the positive cash flow at the completion of the project (Kierulff, 2008; "Modified Internal Rate of Return," 2009).

Compare Contrast -- There are pros and cons for each of the methods of budgeting, depending on the circumstances surrounding the event, and/or, the type of organization. Each methodology is more appropriate for certain types of transactions. For instance, in the real-world, a small business with one investment or decision would be well served to use NPV, or modify it with IRR if they wanted a more accurate appraisal of the return on investment for, say, a new piece of equipment. IRR is valuable for more complicated, or multidimensional projects, venture capital, private equity, and as an instrument is useful to compare investments of different sizes and quality; but does not always weight the cost of capital appropriately. MIRR is complex, and allows for differentiated costs of capital, but is likely overkill for the entrepreneur; but especially useful for real estate transactions (Gallinelli, 2008). An exaggerated rate of return may occur within each model, both positive and negative, depending on the project. Thus, the tool used must be appropriate for the question being answered: type of investment, value of investment, cost of capital, short- and long-term cash flow issues, and expected result (Bruner, n.d.).

Table 1 -- Comparison of Capital Budgeting Methodologies

Method

PRO

CON

NPV

More accurate reflection of value to the business

Best tool for mutually exclusive projects

Recognizes the time value of money concept

Recognizes the risk associated with future cash flow

Instrument does not tell when positive NPV is achieved

Assumes capital is abundant

Focus is on cash flow, not earnings

Does not adequately allow for risky investments

IRR

Popular with venture capital and private equity

Easier to compare investments of different sizes than NPV

May give better results to situations in which capital is constrained

Better instrument of evaluation in situations with changing cash flow

Assumes cash is reinvested at constant rate

Does not always weigh the cost of capital appropriately

Model has problems with projects that have irregular cash flows

Unable to use with single projects

MIRR

Allows for different costs of capital and projects of different duration

Better reflects the value of a project, but only if project is more multidimensional

Better model for real estate investments

Not appropriate for simple projects

More complicated formula and understanding

Not really good measure for smaller investments

Not very good at comparing mutually exclusive alternative investments

REFERENCES

Ansari, S. (2000).The Capital Budgeting Process. McGraw Hill.

Berkovitch, E. (2004). "Why the NPV Criterion does not Maximize NPV." Review of Financial Studies, 17 (1): 239-255. Cited in:

http://rfs.oxfordjournals.org/cgi/content/abstract/17/1/239

Brealey, R.A. (2008). Principals of Corporate Finance. McGraw Hill.

Bruner, R. (n.d.). "What is Capital Budgeting?" Cited in:

www.exinfm.com/training/capitalbudgeting.doc

Dayananda, et.al. (2008). Capital Budgeting: Financial Appraisal of Investment

Projects. Cambridge University Press.

Gallinelli, F. (2008). "Stirring the Alphabet Soup of Real Estate Investment, Part 2."

RealData.Com. Cited in:

http://www.realdata.com/ls/alphabet-soup-part2.html

"Internal Rate of Return." (2009). Online Financial Dictionary. Cited in:

http://www.ofdict.com/definition/internal-rate-of-return.php

"Investment Decisions -- Capital Budgeting." (n.d.). FAO Corporate Document

Repository. Cited in:

http://www.fao.org/docrep/w4343e/w4343e07.htm

Kierulff, H..… READ MORE

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