Capital Budgeting Decision Analysis

The assignment delves into the crucial aspect of capital budgeting decisions within organizations. It examines theoretical frameworks, including net present value (NPV) and internal rate of return (IRR), and discusses practical applications in evaluating investment projects. The analysis considers factors influencing capital budgeting decisions, such as risk, uncertainty, and political considerations. Furthermore, it explores alternative capital budgeting techniques and their respective advantages and disadvantages.

Financial analysis and Management
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Contents
Introduction................................................................................................................................3
Critical Discussion of Usefulness of the Respective Capital Investment Appraisal Measures
Recommendations for Selection of an Option...........................................................................4
Accounting Rate of Return.....................................................................................................4
Payback period.......................................................................................................................4
Net Present Value (NPV).......................................................................................................5
Internal Rate of return (IRR)..................................................................................................6
Recommendation....................................................................................................................7
Reasons for payback favor to the G120 option and NPV the Z125 option in the given case....8
Analysis of Confidence of Finance Director in the given case about achieving IRR would in
excess of 15% for both options of G120 and Z125....................................................................9
Impact of the Investment Option of a potential purchase of new engine build plant of cost
£2,080,000 with a NPV of £140,800 on the G120 and Z125 investment decision..................10
Conclusion................................................................................................................................11
References................................................................................................................................13
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Introduction
The present report aims to present an analysis of the investment proposals that are
considered by SD Ltd for investing in new machinery. The capital budgeting decisions are
very crucial for a business entity in order to select the most profitable investment option that
will improve the business performance in future context. The capital budgeting can be stated
to be a step by step process that a business entity uses for determining the benefits of an
investment project (Bhimani, 2006). The capital budgeting seeks to analyse the risks and
returns of a project and thus help in selecting the most attractive option based on their
accountability. There are various techniques of capital budgeting used by project managers
for analyzing the profitability of a project that are accounting rate of return, payback period,
net present value and internal rate of return. The business entities are able to select the most
appropriate investment option as per their requirements based on the results of the capital
budgeting techniques. The business entities can predict the future cash flows through the help
of capital budgeting decisions for developing their potential growth strategies and objectives
(Huang, 2010).
The selection of a most feasible investment strategy is essential for business entities to
achieving competitive advantage in the market place and thus ensuring their sustainable
growth and development (Peterson and Fabozzi, 2004). The business expansion and
development depends on the capital budgeting decisions and in this context this report
evaluates the investment options presented before SD Ltd. The SD Ltd is considering to
either implementing G120 or Z125 machinery for automating its production and thus
reducing its operational cost. In this context, the report provides an analysis of different
capital investment appraisal measures in order to select the most appropriate option.
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Critical Discussion of Usefulness of the Respective Capital Investment Appraisal
Measures Recommendations for Selection of an Option
The different capital investment appraisal measures are analyzed as follows:
Accounting Rate of Return
It is also known as average rate of return (ARR) and is used for selecting the
feasibility of an investment option. It is calculated through dividing the average annual
accounting profit to be realized from a project by initial investment. The project is accepted if
the ARR is greater than required rate of return (Baker and English, 2011). The main
advantage of use of this method is that is easy to implement and to use for analyzing the
feasibility of a project (Besley and Brigham, 2008). The method is not largely used by the
project managers during capital budgeting decisions as it does not take into account the
concept of time value of money that can impact the profit generated from a project with
change in the interest rates. The ARR method is also mainly based on computing the profits
that can be easily manipulated with the change in deprecation methods. Thus, it can provide
misleading results during analysis and selection of different investment options. It does not
take into account the cash flows realized from an investment proposal and therefore do not
provide accurate results (Nwogugu, 2017).
In addition to this, the method also does not take into consideration the increase in
risks of the project over long period of time. The method also is not appropriate for
comparison of different projects as it does not consider other factors that should be evaluated
for comparison of different projects. The accounting rate of return for the two given options
for investment in machinery is different as given in the table. The ARR for G120 is 18% and
for the Z125 is 14.7% and therefore on the basis of ARR the SD Ltd is recommended to
select the investment proposal of investing in G120 machinery (Wilson, 2015).
Payback period
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The payback period is referred to as time-period required for recovering the cost of an
investment. The payback period helps in taking decisions regarding to invest in a project or
not. The longer the payback period of a project less it is suitable for investment purpose. The
concept is very simple to be used and also to be understood. It can be calculated even without
the use of a calculator. The method specifically emphasizes on the time required to recover
the cost of a project and as such provides an assessment of its risk. Therefore, it can be used
to compare the risks of different projects on the basis of their payback periods (Holmén and
Pramborg, 2007).
The method also has a drawback of not considering the concept of time value of
money while determining the feasibility of a project. It only focuses on assessing the liquidity
of a project and does not consider its profitability. The method does not take into account the
cash flows that will be received after the payback period. As per this method, it can be said
that SD Ltd should consider the project G120 for investment in comparison to Z125 as it have
less payback period (Mushaho and Mbabazize, 2015).
Net Present Value (NPV)
The net present value can be stated as the difference between cash inflows and the
cash outflows that is calculated for analyzing the profitability of a project (McClure, 2004). It
is calculated through the use of following formula:
Ct = net cash inflows occurred during the time-period t
Co =overall cost of investment
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r=discount-rate
t=number of time-periods
The NPV evaluates the feasibility of a project through calculation and summation of
all the discounted cash flows of a project that is either positive or negative. Thus, it is highly
sensitive to discount rates. The project is accepted if it is expected to generate positive IRR
and rejected if it provides negative IRR. The NPV method estimates the feasibility of a
project on the basis of the cost of capital and the risk involved in estimating the future cash
flows. The NPV method also is very useful for determining the expected value a project will
create for a company (Bierman and Smidt, 2003).
The project managers use the capital budgeting technique of NPV for calculating the
cash flows of different investment options separately. However, its biggest disadvantage is
that it is based on numerous assumptions about the cost of capital of a company. Therefore, if
the cost of capital of an entity is considered to be very low it can result in making sub-optimal
investments and it is very high then it can result in not selection of many appropriate
investment options. As such, based on the NPV of the given two investment options for SD
Ltd, the Z125 machinery investment option should be selected as its NPV is £420,194 and
£284,864 (Bierman and Smidt, 2007).
Internal Rate of return (IRR)
The internal rate of return (IRR) in capital budgeting decisions is used to assess the
profitability of potential investment options. It is said to be a discount rate at which the NPV
of all the cash inflows from a project becomes zero. It is thus used for calculating the
breakeven point of a project. The most significant advantage of the use of this method is that
it considers the concept of time value of money in analyzing the feasibility of a project. Also,
it is simple to understand and so largely used by accounting managers in capital budgeting
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decisions. The decisions regarding the acceptance or rejection of a project in this technique is
not based on the required rate of return. The major disadvantage of the method is that it does
not consider the economies of scale Also, it does not analyse the profitability of a project on
the basis of the project size. The cash flows are compared with the capital amount and
therefore the projects with different capital investment cannot be compared as higher IRR
will be obtained from a small project. The IRR method only emphasizes on the estimated
cash flows of a project and does not consider the potential costs that can impact its future
profitability. The method also cannot be used when the discount rate of a project is not
known. As per the internal rate of return, the G120 investment option is selected in
comparison to Z125 because it provides larger IRR (Brigham and Ehrhardt, 2007).
Recommendation
On the basis of analysis of all the four capital investment appraisal measures, it can be
said that SD Ltd should select the investment option for investing in G120 machinery because
it has higher IRR, lower payback period and higher ARR. The lower payback period of G120
investment option indicates that it has minimum risk and therefore it will recover its cost of
investment in short period of time. The accounting return of return is also higher which
means that G120 investment option will help in generation of more net income in comparison
to the other option. The IRR of G120 option is higher indicating that the rate of return of this
option is higher in comparison to other. The NPV of Z125 is higher as it evaluates the
attractiveness of a project for inviting on the basis of cost of capital. The Z125 is a highly
capital intensive project and as such its NPV value is higher in comparison to G120 option.
Therefore, the most appropriate investment option for SD Ltd is investing in G120 machinery
for improving its production process (Megginson, Lucey and Smart, 2008).
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Reasons for payback favor to the G120 option and NPV the Z125 option in the given
case
As depicted from the given table, the payback and NPV method of capital budgeting
used for analyzing the feasibility of the two given investment options have shown different
results. The payback capital budgeting technique favors G120 option as it has lower payback
time therefore it will recover its cost in small period of time in comparison to other
investment option. On the basis of pay-back method, it can be said that G120 investment
option is less risky as it recover its cost of investment quickly. The NPV method favors Z125
option because it provides maximise wealth to the shareholders as it has larger NPV than
G120 option. The NPV methods calculate the present value of cash flows and derive the
value of a project that will be added to the shareholders wealth. The overall analysis provided
by NPV is based o the cost of capital (Peterson and Fabozzi, 2004). The assessment provided
by the NPV method can be said to be more reliable and therefore the company can consider
the selection of investment option for Z125 machinery. The NPV value can be said to more
reliable as it analyses the profitability of a project o the basis of the concept of time value of
money and also provides results by considering the cash flows to be realized at the end of a
project. Thus, it predicts the best investment option for a company by considering the future
changes in the market place (Pogue, 2010).
However, the payback period method is considered to be less reliable than NPV
method because the results provided by it have not considered the factor of time value of
money. Therefore, the company can select the Z125 machinery investment option as NOV
method is more reliable capital budgeting technique in comparison to payback method.
However, as per my opinion in the given case the G120 option is less risky because the
projects that have payback period less than 3 years are accepted on the basis of their less risk.
The Z125 option has more risk as its payback period is more than 3 years. Therefore, the
company by selecting the G120 option can reduce its risk and by realizing the breakeven
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point earlier can re-invest the funds for earning greater profits. Also, the investing in Z125
would require the company to invest its entire capital budget as it requires more capital (Pratt,
2003). Therefore, the company should play safe and is recommended to invest in the projects
that have less risk that is in G120 option. Both the option does not consider the project size
and therefore on the basis of results of payback period and NPV value, it is suggested that SD
Ltd should select the investment option of G120 because it have less risk. The company is not
in position of taking higher risk due to capital budget constraints and therefore recommended
to select the results obtained from payback period method (Shapiro, 2005).
Analysis of Confidence of Finance Director in the given case about achieving IRR would
in excess of 15% for both options of G120 and Z125
The IRR (Internal Rate of Return) is regarded as the discount rate at which the net
present value of cash flows becomes zero. The internal rate of return is often selected as the
best option to accept or reject a project if the other factors are considered to be constant. On
the other hand, the net present value is said to be the difference between the present value of
cash inflows and outflows. It evaluates the profitability by taking into consideration the value
of a dollar in present with that in the future (Hsu, 2005). The NPV and IRR both evaluates the
profitability of a project by considering the time value of money and are used in combination
by the project managers for analyzing and comparing the investment options. The relation
between NPV and IRR can be used to describe the reason for the confidence of finance
director that IRR would be greater than 15% for both the investment options. The NPV of a
project if is less than zero then IRR is also less than the cost of capital and the project will be
rejected (Griff, 2014).
This is because the rate of return of a project is less than the expenditure incurred
during carrying the project and therefore it is not able to realize its breakeven point.
However, if NPV is equal to zero, then IRR is equal to the cost of capital and the project will
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be probably rejected as it will provides less return (Al-Ani, 2015). However, if NPV is
greater than zero, then IRR is also greater than cost of capital and the project is accepted on
the basis of providing it large profitability. As such, in the given scenario, the NPV is
calculated through applying the cost of capital to be 15%. The NPV of both the projects as
evaluated are positive and therefore it can be said that IRR of both the projects will be above
15%. This is because the IRR is calculated at the discount rate when NPV becomes zero.
Therefore, the discount rate of both the projects would be above 15% to arrive at NPV to be
zero which is calculated at the cost of capital rate of 15% (Lunkes et al., 2015).
Impact of the Investment Option of a potential purchase of new engine plant
The evaluation of the third investment option of new machinery with cost of
£2,080,000 and NPV of £140,800 for SD Ltd can be done through considering the following
two assumptions:
 Assumption 1: This option assumes that only one investment cession will be
considered by SD Ltd out of the total three options. In this case, there will be no
impact of the given option as its NPV is less than the NPV’s of both G120 and Z125.
Hence, it can be said that in the case of company only selecting one investment option
it will either choose G120 and Z125 (Venkatesh and Gugloth, 2017).
 Assumption 2: This assumption assumes that two investment options from the three
can be selected. In this case, the two investment options that can be selected by SD
Ltd in combination are G120 and the new investment option. This is because the total
capital budget of the company for investment purpose in the new machinery is equal
to the overall initial investment that is to be made in investing the machinery option of
Z125, that is, £3,232,000. As such, the total capital budget that will be required for
undertaking both the investment options of G120 and the given new investment
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option will be £ 3,19,2000. This is the summation of the initial investment for G120
and the new investment option. Also, the combined NPV of both the projects will be
£425,664 that is greater than the NPV of Z125 machinery investment option of
£420,194. However, the company cannot take the investment decision to invest in the
given new investment option and the Z125 option. This is due to the fact that SD Ltd
only has a maximum capital budget that is equal to the initial investment required for
investing in the Z125 machinery (Bierman and Smidt, 2007). Therefore, it is not
feasible for the company to undertake any other investment option in addition of the
Z125 option. As such, it can be said that the company if want to select the two
investment options then it should decide to invest in the new machinery of the given
investment option and the G120. This will help the company to achieve higher NPV
in comparison to investing only in the investment option of Z125 within its capital
budget constraints (Kengatharan, 2016).
Conclusion
Thus, it can be said from the overall discussion held in the report that capital
budgeting decisions plays a critical role for achieving success from a capital project. The
capital budgeting techniques analyzed in the report, that are, accounting rate of return,
internal rate of return, net present value and the payback period are very important for
evaluating the potential worth of a project, These techniques provides a base for accepting or
rejecting a project under consideration based on its potential profitability and returns. The SD
Ltd should select the investment option from the given tow machinery of G120 and Z125
after thorough analysis of the results obtained from the use of capital budgeting techniques.
This is essential so that the company can achieve its strategic goals and objectives which it
wants to achieve through installation of new machinery. The results obtained from the capital
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budgeting techniques in combination with the business requirements would decide the
selection of the most appropriate investment option.
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