Findings
Discuss about the Factors Determining Selection Of Capital Budgeting.
Capital budgeting is a process followed by the companies or organizations in order to evaluate their investment projects and to take the related decisions. It is a concept which consists of some methods that are been used by management for examining the proposals and select the best alternative. These techniques allows the companies to choose the investment, which is more feasible and profitable for the business. Making an investment related decision is considered to be a challenging task for the management as it involves allocation and application of business’s funds to the most viable and suitable project that is expected to give high returns in future (Ahmed, 2013). Therefore, it is very important for the organization to critically evaluate a project from all its financial aspects in order to take appropriate decisions. There are several reasons why companies go for capital budgeting techniques. Out of them, some are to know about the most profitable capital expenditure, to determine the returns derived by replacing old and existing asset and to select the best proposal among the available ones. In addition, the methods help in identifying the amount required for making the investment along with the sources from where the funds can be raised (Gotze, Northcott & Schuster, 2016).
KKP Ltd is leading company engaged in the instrumentation and automation business. The executives and the directors of the corporation are looking forward to launch a new type of proximity sensor for the food industry. For that, the organization has incurred a lot of money in conducting a market research along with the start-up cost of building the new machinery. The company has adopted some quantitative and qualitative techniques to evaluate this proposal. Quantitative tools include capital budgeting methods such as NPV, payback period, profitability index and IRR. On the other side, qualitative tools comprises of some non-financial issues that are been discussed in the later part of the report.
In order to evaluate the investment proposal of KKP, the managers of the organization has used certain quantitative and qualitative methods that are been discussed below. Based on such findings, the organization will decide whether to go further with the project or not.
Various investment appraisal methods are been used in this approach. These techniques measures a project from all the financial aspects such as profitability, feasibility and viability. They are as follows:
- Payback period
Quantitative
It is the simplest method used for evaluating an investment project. It identifies the number of years taken by a project to recoup its initial investment. In other words, it reflects the time- period within which the proposal will recover its initial outlay of cash. The payback period calculated so that management can have an idea about the sustainability of the project and can decide that whether it will be profitable to take this project further or not. Generally, companies has a standard payback period against which the calculated one is compared. If the standard one is more than the calculated that means the project should be accepted and must be rejected in case of vice versa (Atrill & McLaney, 2009).
Refer to Appendix, it is observed that in case of KKP Ltd., when calculated the payback period is more than the useful life of the machine. This means the machine is not capable enough to generate cash inflows throughout its entire life of five years. All the cash flows are in negative, which means the project should not be accepted, as it will take many more years to recoup the initial investment and to generate profitable cash inflows in future. Moreover, the targeted value for the payback period is 3 years and the calculated one is way more than that. Therefore, it will be better to reject the proposal.
- Discounted payback period
Another capital budgeting procedure that measures the profitability of a project. Unlike the simple payback period, it uses the discounted cash flows to calculate the amount of time required to breakeven from the initial capital expenditure. As per the calculation done and shown in appendix, it is observed that by this method also the project of KPP Ltd is not feasible as it is not able to recuperate the funds invested in it initially, within the period of five years (Baker & English, 2011). In addition, the calculated DPBP is more than the targeted period of 1.5 years. So, the project is not suitable.
- Net present value
It is the most commonly used method, which measures the profitability of a project. It is the amount, which is in excess of the present values of cash inflow over the PV of cash outflow. It is the most reliable and authentic technique used by the managers for evaluating their investment proposals. The decision rule of NPV is that accept the project only when the net present value of that particular proposal is greater than zero and is positive. This implies that the projected earnings generated by the project are more than the anticipated costs. If the NPV is less than zero than it become negative and it is better to reject the proposal. It takes into account the concept of time value of money (Bierman & Smidt, 2012).
Qualitative
Referring to Appendix, the NPV of building new machinery is negative which means the cash inflows generated in the coming five years are less than the initial investment made. This indicates that the project is not profitable for the company as for the next five years; KKP Ltd will be facing losses only. The project has a negative NPV of -$474204.81 which means the project will not give positive returns in its whole life of five years.
- Internal Rate of return
It is a rate where the NPV is zero, which means the PV of cash outflow is equal to PV of cash inflow. Generally, projects having high IRR are considered more desirable and are acceptable if the rate is more than the required cost of capital. An IRR can also be negative in case where the cash flows are less than the initial outlay. Negative IRR is the rate at which the project or the investment made is losing money (Brigham & Houston, 2015).
The proposal of building a new machinery gives KKP an IRR of -7%. (Refer appendix). This is due to the negative NPV of the project. It indicates that required rate of return of the proposal is more than its IRR. Therefore, the project should be rejected.
- Profitability Index
It identifies the relationship between the cost and benefits of a project by calculating an index. If PI is equal to one or less than one, then it means that present values of the proposal are less than its initial investment. In case of KKP Ltd., the PI is 0.54 that is less than one and indicates that the project is not feasible.
There are some non-financial issues also which are to be considered by KKP Ltd while making investment in building a new machinery. These include the environmental concerns as the decision of such capital investment can have varying degree of impact on the environment. Before launching the sensor, the management must take into account its effects on the environment. Apart from this, some ethical considerations like safety of employee and local employment can be affected by investing into a new machinery, irrespective of the financial benefits.
From the above discussed issues, it is recommended that the company should not go for this project as it has negative NPV, IRR and a low profitability index. Moreover, the discounted and non-discounted payback period of the project are more than its entire life. This means that the proposal is not able to generate cash flows that are enough for recovering the initial outlay made. Moreover, it is not profitable as the present value of future cash inflows is less than the PV of cash outflow. Furthermore, making investment in it can affect the environment of the company and may affect the employees. However, the recommendations can be justified by looking at the quantitative methods used for the evaluation. The tools used provide the most reliable basis for taking decisions related to capital investments. Overall, the company should avoid investing in the proposal, as it will not be profitable.
Apart from the above given recommendation, it can be further recommended to the company that in order to generate profits it should increase the number of units sold per year. This will led to the inflow of cash in the business and recover the reduction of $17,000 in the sale of gas analysers that happened due to the launch of proximity sensor. If the net cash inflows increases, the present value of them will also rise which ultimately make the project feasible and profitable. So in order to launch the proximity sensors in the food industry, the company needs to increase its sales as reduction in the same have a negative effect on the new venture.
Conclusion
From the above report, it is concluded that it is very important for the management to consider the authentic investment appraisal methods to evaluate the proposal before making an investment in it. Overall, it is very essential for the companies to consider all the financial and non-financial aspects of the investment project while taking the decision related to the feasibility and profitability of the proposal.
References
Ahmed, I.E. (2013). Factors determining the selection of capital budgeting techniques. Journal of Finance and Investment Analysis, 2(2),77-88.
Atrill, P. &McLaney, E. (2009). Management accounting for decision makers (4th ed.). England: Pearson Education.
Baker, H.K. &English, P. (2011). Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects. New Jersey: John Wiley & Sons.
Bierman Jr, H., &Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects (9th ed.). New York: Routledge.
Brigham, E.F. &Houston, J.F. (2015). Fundamentals of Financial Management. Cengage Learning.
Gotze, U., Northcott, D. &Schuster, P. (2016). INVESTMENT APPRAISAL (2nd ed.). New York: SPRINGER-VERLAG BERLIN AN.
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