Question

To support growth strategies and combat competition with rivals, businesses seek external capital to further develop products and services in hopes to create new sales opportunities. Since capital investment often involves a huge money investment, longer time engagement and risks of uncertainties, any decision shall not be taken lightly and shall be carefully evaluated before putting money to start a long-term project. The goal is to ultimately make the right accept/reject decision

-Discuss criteria and techniques used to evaluate a capital project. Which criteria and techniques do you consider the most useful? As a financial manager, would you use the same criteria or evaluation techniques for any capital project? Why or why not?  

Answer 1

The criteria to evaluate the projects is known as Capital Budgeting, it is one of the appraising techniques of investment decisions.

it means ' firms decisions to invest its funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of year.

CRITERION - METHODS OF APPRAISAL

The capital budget appraisal methods or techniques for evaluation of investment proposals will help the company to decide the desirability of an investment proposal, depending upon their relative income generating capacity and rank them in order if their desirability.

Appraisal methods

Traditional Methods( Time value of money is not considered)

• Payback Period Method:

This method enables to evaluate the number of years it takes for the firm to recover its original investments by net returns before depreciation, but after taxes. Criteria for selection of project is the shorter payback period.

• Accounting rate of return:

This technique uses the accounting information revealed by the financial statements to measure the profitability of an investment proposal. Determined by dividing the average income after taxes by the average investment. Criteria for selection of project is the higher ARR.

the main drawback of traditional methods is not taking into consideration of Time factor, as a cause of which following methods of capital appraisal was developed:

Discounted cash Flow techniques:

• NPV (net present value):

it is the method of calculating the present value of cash flows (inflows and outflows) of an investment proposal using the cost of capital as an appropriate discounting rate. The net present value will be arrived at by subtracting the present value of cash outflows from the present value of cash inflows. Criteria for selection of project is the NPV > 0

• IRR (internal rate of return)

It is the interest rate which equates the present value of expected future cash inflows with the initial capital outlay. In other words, it is the rate at which NPV is equal to Zero. Criteria for selection of project is the IRR > K (Cost of Capital)

• Profitability Index:

Also known as ' Benefit Cost Ratio'. "The ratio of the present value of future net cash inflows to the present value of cash outflows". Criteria for selection of project is the PI >1

• MIRR (modified internal rate of return):

Under MIRR the earlier cash flows are reinvested at firm's rate of return and finding out the terminal value. MIRR is the rate at which present value of terminal values equal to outflow .

• DISCOUNTED PAYBACK PERIOD:

Similar to payback period wherein, discounting factor or the time value of money is considered. Criteria for selection of project is the shorter payback period.

I PREFER TIME VALUE TECHNIQUES TO EVALUATE THE PROJECTS AS THESE ARE DERIVED CONSIDERING THE FOLLOWINGS:

1. INFLATION
2. RISK
3. TIME FACTOR
4. PERSONAL CONSUMPTION PREFERENCE
5. INVESTMENT OPPORTUNITIES

The above methods should be capable of producing the followings:

• Help company to rank the proposals
• distinguish between acceptable and non acceptable project
• criteria to choose among alternative projects
• should account the pattern of cash flows