Get Instant Help From 5000+ Experts For
question

Writing: Get your essay and assignment written from scratch by PhD expert

Rewriting: Paraphrase or rewrite your friend's essay with similar meaning at reduced cost

Editing:Proofread your work by experts and improve grade at Lowest cost

And Improve Your Grades
myassignmenthelp.com
loader
Phone no. Missing!

Enter phone no. to receive critical updates and urgent messages !

Attach file

Error goes here

Files Missing!

Please upload all relevant files for quick & complete assistance.

Guaranteed Higher Grade!
Free Quote
wave

The most common approaches used in capital budgeting

Capital budgeting is a process which is used for evaluating investment or projects. This method is used for taking decisions about long term investment of capital of company (Kengatharan 2016). Capital budgeting method is considered to be very important as it creates measurability and accountability. With the help of capital budgeting techniques, a project is chosen that adds value to the company. Therefore, capital budgeting is a process which helps the investors in determining the value of investment project (Sarwary 2019).

The most common approaches used in capital budgeting are payback period, accounting rate of return and net present value.

Payback period: This method is used for ascertaining the time period taken by the project to recover the potential investment. It denotes the time taken to reach the break-even point. The payback period of the project is calculated by considering annual cash flows and initial investment (Gorshkov et al. 2018). When the payback period is shorter, then it is suggested to undertake the project as it indicates the hat initial investment will be recovered within a short span of time and when the payback period is longer, then it is recommended to reject the project. This method is used by managers for determining whether to proceed with investment or not (Gorshkov, Murgul and Oliynyk 2016). This method is used for ascertaining investment returns by financial professionals and investors. In this method time value of money is not taken into consideration.

Accounting rate of return: This method is used for ascertaining return from investment and for making capital budgeting decisions. In other words, this method helps in determining annual percentage rate of return of project (Accounting rate of return 2022). The formula for ascertaining ARR is to divide average annual and average investment. When ARR of project is more than cost of capital then it is recommended to accept the project as it indicates that investment is attractive and profit has been generated from project whereas when ARR is negative or lesser than cost of capital it is suggested not to accept the investment as it will not generate any profit.  Hence, ARR is the minimum rate of return that is accepted by an investor for project that compensates for given level of risk (Bragg and Bragg 2022). This method provides clear profitability. In this method time value of money is not taken into consideration and at the same time cash flows are also not taken into consideration.

Net present value method: This method is used for ascertaining present value of future cash flows that are generated by the project. Simply this method helps in determining whether investment in project will generate profit in future or not that is whether the project will be profitable (Gallo 2014). The formula used for ascertaining the net present value of the project is the present value of cash inflows – the present value of cash outflows. When the net present value of the project is positive then it is suggested to undertake the project as it indicates the hat project will generate in the future period of time and when it is negative it is suggested to reject the project. This method is mostly preferred as the time value of money is taken into consideration (Benamraoui et al. 2016).

Payback period

Payback period
Particulars Cash flow

Cumulative cash flow

0 -£120,000.00 -£120,000.00
1 £24,000.00 -£96,000.00
2 £29,000.00 -£67,000.00
3 £36,000.00 -£31,000.00
4 £41,000.00 £10,000.00
5 £46,000.00 £56,000.00
Payback period (In years) 3.756

Accounting rate of return
Particulars Profit
1 £6,000.00
2 £10,000.00
3 £19,000.00
4 £26,000.00
5 £32,000.00
Average profit £18,600.00
Average investment £600,000.00
Accounting rate of return a/b) 3.10%
Net present value
Particulars Cash flow DF @5.08% 1/(1+5.077%)^n Present value
0 -£120,000.00 1 -£120,000.00
1 £24,000.00 0.9517 £22,840.39
2 £29,000.00 0.9057 £26,265.32
3 £36,000.00 0.8619 £31,029.84
4 £41,000.00 0.8203 £33,632.04
5 £46,000.00 0.7807 £35,910.34
Net present value £29,677.93

Working for WACC
Debt (a) £120,000.00
Equity (b) £36,000.00
Total debt and equity (c=a+b) £156,000.00
Weight of debt (d=a/c) 0.7692
Weight of equity (e = b/c) 0.2308
Costof debt (f) 3%
Cost of equity (g) 12%
WACC (f*g)+(d*e) 5.08%

Based on above calculation of payback period it has been seen that payback period of project is 3.756 years which means that time period is shorter. As discussed above shorter payback period indicates attractive investment hence, the project should be accepted as initial investment will be recovered within a time span of 4 years approx. Based on calculation of ARR it has been seen that ARR of project is 3.1% which is lower than cost of capital. Hence, it indicates that project is expected to earn 3 cents out of each pound invested. Based on calculation it has been seen that NPV of project is £29,677.93 which means that it is positive. Hence, as the NPV of project is positive it means that project will generate profit in future and the project should be accepted. This also indicates an attractive investment. Therefore, based on analysis it can be said that the investment in this project is viable and loaded pies should accept the project and proceed with it.

Along with the financial factors, loaded pies should also consider some non-financial factors before going ahead with the project. The non-financial factors that should be taken into consideration are: strategic factors: companies generally prefer the projects that gives focus on strategic viewpoints. When the project is long-term in nature the focus is given on reducing the weakness rather than maximizing the profit whereas when the project is short-term in nature the primary focus is given on earning net income. Technological factors: For remaining in the industry, technological factors are common to every industrial establishment as it results in the reduction of input consumption, enhancement of quality of product, reduction of cost of production, etc. Obsolescence, meeting with unskilled employees, etc results in technological risk (Ainin et al. 2015). Hence, before going ahead with the project it is very important to look at both financial as well as non-financial factors so that investment can be viable and profitable in the future.

Accounting rate of return

New WACC
Debt (a) £40,000.00
Equity (b) £36,000.00
Total debt and equity (c=a+b) £76,000.00
Weight of debt (d=a/c) 0.5263
Weight of equity (e = b/c) 0.4737
Costof debt (f) 3%
Cost of equity (g) 12%
WACC (f*g)+(d*e) 7.26%

The two external sources of finance for the project are:

Equity share capital: For raising finance shares are issued by limited companies and value of shares are disclosed in the balance sheet of the company. For big companies equity shares are considered as common source of finance and it cannot be used by every business as it is governed by many legislations. Share of ownership rights is considered as key feature of equity share and as result rights of current shareholders are diluted to some extent. Financing through equity share capital is considered to be costly as compared to debt financing as the return offered to shareholders in the form of dividends or bonuses is not tax-deductible (Paramasivan and Subramanian 2020). Raising finances through equity share capital is not easy as it requires many legal formalities

Debenture: Companies who prefer debt over equity use another means of finance which is debenture. Financing through debenture is considered to be less costly as compared to equity share capital and it does not share control with investors as payments made to debenture holders are tax-deductible (UDEH 2015). The rest of the process of issue of debenture is the same as the equity issue. It is generally issued to the common public and in this source of finance, necessary obligations need to be complied with. Some cost is involved in issuing debentures and at the same time, they are also collateralized by some assets.

Among both the method of financing, it is generally better to use debenture as compared to equity financing as financing with equity denotes giving awa the equity in the business. Giving of equity means giving all or some control of the company and at the same investors also get involved in the decision making which makes future decision-making complicated. Debt financing is better as taking debt does not provide an ownership stake and also does not lead to the dilution of equity position of owners in business and at the same time it is less expensive source of growth capital when the company is growing at a higher rate. Hence, it is preferred and better to use debenture while financing a project.

Analysis of working capital
Particulars Before expansion After expansion Change
Current assets
Inventory (a) £6,000.00 £10,000.00 £4,000.00
Cash (b) £2,000.00 £4,000.00 £2,000.00
Total current asset (c=a+b) £8,000.00 £14,000.00 £6,000.00
Current liabilities
Trade payable (d) £5,000.00 £10,000.00 £5,000.00
Overdraft (e) £- £3,000.00 £3,000.00
Total current liabilities (f=d+e) £5,000.00 £13,000.00 £8,000.00
Working capital (c-f) £3,000.00 £1,000.00 -£2,000.00

The table presented above shows the analysis of working capital. Analysis of working capital has been done by considering current assets and current liabilities. Based on the analysis it has been seen that inventory before expansion amounted to £4000 and after expansion amounted it amounted to £10000 which indicates that inventory has increased after expansion. Cash before expansion amounted to £2000 and after expansion amounted it amounted to £4000 which indicates that cash has increased after expansion. Trade payable before expansion amounted to £5000 and after expansion amounted it amounted to £10000 which indicates that trade payables has increased after expansion. It has also been seen that before expansion there was no bank overdraft but after expansion loaded pies has incurred bank overdraft of £3000 which has resulted in increase current liabilities. Therefore, before expansion total current assets before expansion amounted to £8000 and after expansion it amounted to £14000 which means that current assets have been increased by £6000 whereas on the other hand before expansion total current liabilities amounted to £5000 and after expansion, it amounted to £13000 which means that current liabilities have been increased by £8000. After expansion working capital amounted to -£2000. Therefore, it has been seen that total current assets are lesser as compared to current liabilities which makes working capital negative. Hence, for meeting current obligations loaded pies should focus on increasing funds and that can be done either by borrowing money or by selling products (Mathuva 2015).

Conclusion

Based on above discussion conclusion can be made that for making effective decisions regarding acceptance or rejection of project capital budgeting should be used as it is a useful tool for evaluating the value of project. It can also be concluded that capital budgeting is also used for raking and evaluating the project that required good capital investment. Based on discussion it can also be concluded that loaded pies should accept the project as it is viable and it will generate profit and returns in future. Based on analysis of working capital it can be concluded that funding should be increased so as to be meet current obligations.

Reference

Accounting rate of return https://www.accaglobal.com, A. (2022) Accounting rate of return | FFM Foundations in Financial Management | Foundations in Accountancy | Students | ACCA | ACCA Global, Accaglobal.com. Available at: https://www.accaglobal.com/in/en/student/exam-support-resources/foundation-level-study-resources/ffm/ffm-technical-articles/rate-return.html (Accessed: 6 April 2022).

Ainin, S., Parveen, F., Moghavvemi, S., Jaafar, N.I. and Shuib, N.L.M., 2015. Factors influencing the use of social media by SMEs and its performance outcomes. Industrial Management & Data Systems.

Benamraoui, A., Jory, S.R., Boojihawon, D.R. and Madichie, N.O., 2016. Net present value analysis and the wealth creation process: A case illustration. The Accounting Educators' Journal, 26.

Bragg, S. and Bragg, S. (2022) Accounting rate of return definition — AccountingTools, AccountingTools. Available at: https://www.accountingtools.com/articles/what-is-the-accounting-rate-of-return.html (Accessed: 6 April 2022).

Gallo, A., 2014. A refresher on net present value. Harvard Business Review, 19.

Gorshkov, A., Murgul, V. and Oliynyk, O., 2016. Forecasted payback period in the case of energy-efficient activities. In MATEC Web of Conferences (Vol. 53, p. 01045). EDP Sciences.

Gorshkov, A.S., Vatin, N.I., Rymkevich, P.P. and Kydrevich, O.O., 2018. Payback period of investments in energy saving. Magazine of Civil Engineering, (2).

Kengatharan, L., 2016. Capital budgeting theory and practice: a review and agenda for future research. Applied Economics and Finance, 3(2), pp.15-38.

Mathuva, D., 2015. The Influence of working capital management components on corporate profitability.

Paramasivan, C. and Subramanian, T., 2020. Financial management.

Sarwary, Z., 2019. Capital budgeting techniques in SMEs: A literature review. Journal of Accounting and Finance, 19(3), pp.97-114.

UDEH, S.N., 2015. Sources of Finance.

Cite This Work

To export a reference to this article please select a referencing stye below:

My Assignment Help. (2022). The Essay On Capital Budgeting Techniques And Importance.. Retrieved from https://myassignmenthelp.com/free-samples/es980-financial-strategy/analysis-of-viable-investment-file-A1E3175.html.

"The Essay On Capital Budgeting Techniques And Importance.." My Assignment Help, 2022, https://myassignmenthelp.com/free-samples/es980-financial-strategy/analysis-of-viable-investment-file-A1E3175.html.

My Assignment Help (2022) The Essay On Capital Budgeting Techniques And Importance. [Online]. Available from: https://myassignmenthelp.com/free-samples/es980-financial-strategy/analysis-of-viable-investment-file-A1E3175.html
[Accessed 19 August 2024].

My Assignment Help. 'The Essay On Capital Budgeting Techniques And Importance.' (My Assignment Help, 2022) <https://myassignmenthelp.com/free-samples/es980-financial-strategy/analysis-of-viable-investment-file-A1E3175.html> accessed 19 August 2024.

My Assignment Help. The Essay On Capital Budgeting Techniques And Importance. [Internet]. My Assignment Help. 2022 [cited 19 August 2024]. Available from: https://myassignmenthelp.com/free-samples/es980-financial-strategy/analysis-of-viable-investment-file-A1E3175.html.

Get instant help from 5000+ experts for
question

Writing: Get your essay and assignment written from scratch by PhD expert

Rewriting: Paraphrase or rewrite your friend's essay with similar meaning at reduced cost

Editing: Proofread your work by experts and improve grade at Lowest cost

loader
250 words
Phone no. Missing!

Enter phone no. to receive critical updates and urgent messages !

Attach file

Error goes here

Files Missing!

Please upload all relevant files for quick & complete assistance.

Plagiarism checker
Verify originality of an essay
essay
Generate unique essays in a jiffy
Plagiarism checker
Cite sources with ease
support
Whatsapp
callback
sales
sales chat
Whatsapp
callback
sales chat
close