Alternative Investment Appraisal Methods in Capital Budgeting

This report delves into alternative methods of investment appraisal, including the discounted payback period, profitability index, and modified internal rate of return. It discusses the importance of considering the time value of money and the limitations of each method. The report also addresses the challenges businesses face in making sound capital investment decisions and emphasizes the role of scenario analysis, feasibility studies, and agile management. It outlines a structured process for capital investment decisions, including project identification, screening, feasibility analysis, selection, implementation, and monitoring. The document highlights that external factors like taxes and government regulations also impact businesses.

FUNDAMENTAL OF FINANCIAL MANAGEMENT & CAPITAL BUDGETING
What are some of the alternative method of investment appraisal?
Answer
The alternative methods to investment appraisal have been detailed here-in-below:
(a) Discounted Payback period: Under this method, time value of money is taken into
consideration for the purpose of computing the time period in which the cash outlay
shall be recognised by the company from the project. The computation involves
discounting of cash flow at the Weighted average cost of capital in the said case 15% to
compute the present value of cash flows which is then cumulated and then extrapolated/
interpolated to compute the discounted payback period. It is a better analysis tool
compared to payback period. However, it has a drawback that it does not take
inconsideration the cash flow generated post discounted payback period.
(b) Profitability Index: It is also one of the important tools for analysing investment. Under
the said tool, any project with PI greater than 1 is worth considering and analysing. To
compute Profitability Index of the project, one needs to compute the future cash flows
of the project and discount it using Weighted Average Cost of Capital i.e. 15% in the
said case to derive present value of cash flows. Further, the computed present value of
cash flows shall be divided by cash outflows to compute the profitability index of the
project. The method takes into account the time value of money;(Wilkinson, 2013)
(c) Modified Internal Rate of Return: It is an alternative appraisal tool and used to rank
alternative investment of equal size.
Additional Questions
Many businesses around the world still fail because their capital investment decisions are
based upon a calculation on the back of an envelope and do not take any of the correct factors
into account. Even larger businesses often get this wrong. This is a true sign of poor resource
management.
Answer
Yes, I agree as no tool of analysis is full proof or ensures accurate decision making. Further,
every analysis tool involves a list of assumption which when violated leads to failure of the
calculation and the business altogether. For instance computation of future cash flows is
ingrained with uncertainty and any change in the same can impact all financial analysis tool
used for decision making. Further, the discounting rate used in computation of present cash
flows is also a critical factor as the rate at which loan is taken to finance the project
significantly matters.

The timing of cash flows also a critical factor as if the timing cash flows changes the same
can impact the feasibility of the project to a greater extent. Since the aforesaid involves a lot
of assumption and expertise, in addition, external factors also pay a crucial role, an active
allocation of resource along with agile management is necessary in decision making.
Further, the changes in environment between the time of decision making and time of
execution can impact the cash flow. The other factors that impact businesses include:
(a) Taxes;
(b) Government Rules and regulations etc.
Alternative method of investment appraisal has been detailed here-in-below:
(d) Discounted Payback period: Under this method, time value of money is taken into
consideration for the purpose of computing the time period in which the cash outlay
shall be recognised by the company from the project. The computation involves
discounting of cash flow at the Weighted average cost of capital in the said case 15% to
compute the present value of cash flows which is then cumulated and then extrapolated/
interpolated to compute the discounted payback period. It is a better analysis tool
compared to payback period. However, it has a drawback that it does not take
inconsideration the cash flow generated post discounted payback period.
Limitation:
(a) The method does not consider cash flows post discounting period;
(b) The method cannot be used for computation of return of project;
(c) Inherent weakness of Capital Budgeting.
(e) Profitability Index: It is also one of the important tools for analysing investment. Under
the said tool, any project with PI greater than 1 is worth considering and analysing. To
compute Profitability Index of the project, one needs to compute the future cash flows
of the project and discount it using Weighted Average Cost of Capital i.e. 15% in the
said case to derive present value of cash flows. Further, the computed present value of
cash flows shall be divided by cash outflows to compute the profitability index of the
project. The method takes into account the time value of money;(Wilkinson, 2013)
Limitation:
(a) Estimation is required for Weighted Average cost of Capital;
(b) The method cannot be used for deciding mutually exclusive projects;
(c) Inherent weakness of Capital Budgeting
(f) Modified Internal Rate of Return: It is an alternative appraisal tool and used to rank
alternative investment of equal size.

Limitation:
(a) Inherent weakness of Capital Budgeting
How do you think that capital budgeting decisions should ideally be made by different types of
organisations?
The process that should be a part of making a capital investment decision shall involve the
following steps:
 Identifying the different project which company can invest in;
 Defining the project and screening of the same;
 Feasibility analysis on the basis of scenario analysis of cash flows and above stated
financial tools;
 Selecting the profitable projects that pass through screening;
 Implementing the project;
 Monitoring.
References
Wilkinson, J., 2013, Profitability Index Method Formula, [Online]
Available at: https://strategiccfo.com/profitability-index-method-formula/
[Accessed 23 September 2018].