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Buy custom The Effectiveness of NPV in Evaluating the Capital Budget essay

The paper mainly focuses on the effectiveness of Net Present Value as a tool for evaluating the viability of the capital budget in a firm. Capital budgeting is the process of evaluating, comparing and selecting the projects required in a company for the smooth operation of activities. It is a mandatory tool for management practices in an organization. It helps the financial manager in decisions regarding the choice of investments with satisfactory rates of return and cash flows. A number of tools help the manger to decide onto which investments are viable for the business to undertake. NPV analyses the investment viable projects for the business. These must always be the physical assets only. The projects are exceptionally large in terms of money and their scope. It employs the use of discounted cash flows in its evaluation criteria. It is the most convenient method, because it deals with both time and risk variables present for the projects. In other words, NPV evaluates the cash flows yet to be delivered by one project through the process of discounting them back to the time, currently using the time span of the entire project (t) under the company’s weighted mean cost of capital (i). A positive result means that the project is viable, and a negative result shows that the company should not venture into this project. The NPV goes further to assess the financial viability of the project; which is financially worthwhile, if the result is above zero. This evaluation tool is more convenient and mathematical as compared to other available ones. It also speaks for itself in the value of time taken to gain some money as compared to other tools. All these are attributes it has over other evaluation methods like Payback period, Discounted Payback Period. It is accurate as compared to the Internal Rate of Return and the Profitability Index.

Introduction

Capital budgeting is often employed in various organizations in order to understand their market situation within a truly competitive environment. It is the process of evaluating, comparing and selecting the projects required in a company for the smooth operation of its activities. This is a mandatory tool for management practices in an organization. It helps the financial manager in decisions regarding the choice of investments with satisfactory rates of return and cash flows. A number of methods help the manger to decide onto which investments are viable for the business to undertake. These include Net Present Value (NPV) and Internal Rate of Return (IRR) among others. NPV scores above all the other tools in capital evaluation. A financial manager will then make an informed decision and choose between two or more alternatives available for the selection in the market (Croci, 2009).

Capital is an extremely limited source of a business. Commercial banks and other financial institutions have finite reserves where they may lend to the individuals, governments and corporations from. Each bank must maintain its deposits as reserves. Thus, they are compelled to be really selective in extending credit lines to customers. Even if the banks were in a position to lend unconditionally to these companies, the management would still have the baggage of dealing with the right quantity of credit that will salvage the company from bankrupts.

On a firm’s level of financial obligation, there are limited borrowing resources. Therefore, these resources should be on the most viable investment opportunities. Increasing shareholders would not mean increased capital to the company. This only implies that the capital is spread among several individuals or corporations. As the number of stock increases in a company then, probably, the number of individual stockholders would decrease. Overall, whatever type of capital, the bottom line is that it is limited in its funding criteria to the business. In order to select the best capital investment in the market, it is crucial for the firm to follow the basic steps in its financial sector.

I.          Identification of potential opportunities

It is proper for the company in question to identify the available opportunities. The business entity may take several pathways regarding this noble course. The firm must identify the projects that may require further investigations and the ones that have no impact on the firm (Adrian, 2009). If a viable option is not readily available, then it may cost the firm a lot of money in the ultimate end.

II.        Evaluation of opportunities

After identification the evaluation of the available opportunities comes. This involves the determination of what investments are best for the company, because they should be connected to the firm’s strategy. The opportunities should be realistic to the current situation, because some investments need to be put off until better times.

III.       Cash flow

This involves the determination of the quantity of cash flows needed for the project realization. What amount of cash will be in circulation due to the investment in question? It involves an estimation of the amount of cash in circulation due to the investment in question; basically, it will be some form of guesswork. However, this step is exceedingly mathematical, so the best preferable scenarios should not be used.  Instead, one should preferably use fractions in order to come up with better solutions. Anyway, the odds in this situation are not viable for new projects.

 

.           IV. Selection of projects

After the careful investigation of the projects, it is time for the selection of the best breeds from a flock of ideas. Here, one chooses the right mixture of projects for the company. They must be perfectly polished before the final decision is in place. This is logical, because every project has merits and demerits; thus, it is vital to weigh both advantages and disadvantages in order to come up with a viable project. This combination should work out for the company with an immediate effect (Denison, 2009).

V.        Implementation

Implementation is the last step which comes after the decision on the viable investments. This is the time to implement the project. It is not related to budgeting processes and procedures; but it ensures that all sequences therein are in the right order and by the law. After the start of the project, a constant supervision must ensure the viability of all financial resources.

Effectiveness of NPV in the Evaluation of Capital Budgeting

NPV is one of the tools necessary for the evaluation of the Capital budget of a company. It therefore analyses the investment projects viable for the business. These must always be the physical assets only. The projects are exceptionally large in terms of money and their scope. The most convenient way of analysis is the Discounted Cash Flows method, because it deals with both time and risk variables present for the projects. In other words, NPV evaluates the cash flows yet to be delivered by one project through the process of discounting them back to the time, currently using the time span of the entire project (t) under the company’s weighted mean cost of capital (i). A positive result means that the project is viable, and a negative result shows that the company should not venture into this project.

Furthermore, there are other tools used in this process including the following ones: Internal Rate Return (IRR); Accounting Rate of Return (ROCE, ROI or ARR); Payback or Discounted Payback; and the Discounted Cash Flow. Practically speaking, it abundantly evident that the Net Present Value (NPV) scores above all other tools in the market. Each tool has its own advantages and disadvantages; therefore, the tool in question here is also not behind this common phenomenon (Dobbs, 2009).

There are certain steps that should be taken before a capital project is launched. These factors emphasize the viability of the type of tool for the whole project, and come as following:

I.         The initial project’s cost;

II.        The expenditure phase characteristics;

III.      The investment’s life estimation;

IV.      The timing and amount of cash flow;

V.        The effect on the rest of the undertaking;

VI.      The working capital in need

            Before engaging any project into NPV calculations, it is necessary to define the type of the project under investigation. This will show whether the project is independent or mutually exclusive. Independent projects do not change because of the cash flows of other projects, while mutually exclusive ones are two different projects with two separate ways of accomplishing exactly the same results. This could be because a firm has received a number of bids from the options they requested. A company would not accept two bids at the same time for one project. This becomes a clear example of a mutually exclusive project.

            The decision rule for the NPV is a characteristic of the tool itself. It states that in case of the independent projects, they are viable if the outcome is greater than zero. On the other hand, for the mutually exclusive projects, it states that if the NPV of one project is greater than the NPV of another one, then it is viable. If both possess a negative NPV, then both should not be employed (Giat et al, 2009).

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