Prior to beginning work on this discussion forum, read Chapters 12 and 13 in the Foundations of Financial Management textbook.
For this discussion forum,
Discuss the different capital budgeting techniques covered in Chapter 12, incorporating how risk plays into the decision-making process from Chapter 13.
Graduate school students learn to assess the perspectives of several scholars. Support your response with at least one scholarly and/or credible resource in addition to the text.
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Businesses (aside from non-profits) exist to earn profits and the capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project. According to Malenko (2019), capital budgeting is a critical aspect of financial management that involves evaluating potential investment opportunities in long-term assets or projects. Several techniques are used in capital budgeting, each with its strengths and weaknesses. According to Pettinger (2020), foundations of financial management are essential for understanding how financial decisions are made, how businesses and individuals manage their money, and how financial markets operate. One of the fundamental concepts in financial management is the time value of money; This refers to the idea that money has a different value depending on when it is received or paid. The time value of money is essential for making investment decisions, evaluating financial products, and calculating the cost of borrowing.
Investments carry risk, which is the possibility that the investment will lose value or fail to provide the expected return. Different investments carry different levels of risk, and investors must balance the potential for higher returns with the possibility of losing money. Financial managers must also consider the risks associated with financing options, such as taking on debt or issuing equity. Financial managers also need to understand the concept of diversification; This refers to spreading investments across a range of assets to reduce risk. Diversification can help protect against losses from individual investments and provide opportunities for higher returns. It is essential for managing investment portfolios and reducing risk (Pettinger, 2020). This paper discusses the different capital budgeting techniques covered in Chapter 12 of the Foundations of Financial Management textbook, which are the payback method, net present value (NPV) method, the internal rate of return (IRR) method, profitability index (PI) method and modified internal rate of return (MIRR) method.
The first capita budgeting technique is the payback method. According to Yard (2020), the payback method involves dividing an investment’s initial cost by the expected annual cash inflows to determine the number of years it will take for the investment to break even. The payback method is a simple and easy-to-use technique that quickly measures the risk associated with an investment (Yard (2020). However, it does not consider the time value of money, which can lead to inaccurate results, and it does not consider the cash flows that occur after the payback period, which can be important for long-term investments (Yard (2020). Thus, the payback method is one of the capital budgeting technique.
The second capital budgeting technique is the net present value (NPV) method. According to Wieloch (2019), NPV calculates the present value of a project’s expected cash flows minus the initial investment; This method considers the time value of money and the project’s entire cash flow stream (Wieloch, 2019). A positive NPV indicates that the project is expected to generate a return higher than the required rate of return, while a negative NPV indicates that the project is not likely to be profitable; This method is widely used and provides a comprehensive evaluation of the project’s profitability, but it requires estimating future cash flows and selecting an appropriate discount rate (Wieloch, 2019). Thus, the net present value (NPV) method is another capital budgeting technique.
The third capital budgeting technique is the internal rate of return (IRR) method. According to Pascual et al. (2018), IRR calculates the discount rate that makes the NPV of a project equal to zero; This method is useful for comparing projects with different cash flow patterns and is often used as a decision criterion for investment opportunities. A project with an IRR greater than the required rate of return is expected to be profitable, while a project with an IRR less than the required rate of return is not expected to be profitable; This method may have multiple IRRs or no real solution, making it difficult to interpret the results (Pascual et al., 2018). Thus, the internal rate of return (IRR) is another capital budgeting technique.
The fourth capital budgeting technique is the profitability index (PI) method. According to Rangel et al. (2020), PI calculates the present value of a project’s future cash flows relative to the initial investment; This method is helpful for comparing projects with different sizes and is often used to prioritize investment opportunities (Rangel et al., 2020). A PI greater than 1 indicates that the project is expected to be profitable, while a PI less than 1 indicates that the project is not likely to be profitable; This method is easy to use and provides a clear ranking of investment opportunities, but it requires selecting an appropriate discount rate and assumes that the project is of equal duration (Rangel et al., 2020). Thus, the profitability index (PI) method is another capital budgeting technique.
The final capital budgeting technique is the modified internal rate of return (MIRR) method. According to Xie (2021), MIRR addresses the problems of multiple IRRs and assumes reinvestment of cash flows at the required rate of return; This method calculates the discount rate that equates the present value of future cash inflows to the current value of future cash outflows, including the terminal value of the project and the method provides a more realistic measure of the project’s profitability and is widely used in practice (Xie, 2021). Thus, the modified internal rate of return (MIRR) method is the final capital budgeting technique.
In conclusion, capital budgeting techniques are critical tools for financial management. Each method has its strengths and weaknesses, and the choice of the appropriate method depends on the specific characteristics of the investment opportunity. The NPV method is the most widely used and reliable method for evaluating investment opportunities, but other techniques like the payback period, IRR, and PI also have their place in financial management. Ultimately, the successful application of capital budgeting techniques requires a combination of expertise, experience, and sound judgment. the foundations of financial management are essential for understanding how financial decisions are made, how businesses and individuals manage their money, and how financial markets operate. These principles include the time value of money, risk and return, diversification, financial statements, analytical tools, and the role of financial markets and institutions. Understanding these foundations is crucial for anyone who wants to make informed financial decisions or pursue a career in finance.
De Souza Rangel, A., de Souza Santos, J. C., & Savoia, J. R. F. (2016). Modified profitability index and internal rate of return. Journal of International Business and Economics, 4(2), 13-18. 10.15640/jibe. v4n2a2
Gaspars-Wieloch, H. (2019). Project net present value estimation under uncertainty. Central European Journal of Operations Research, 27(1), 179-197.
Malenko, A. (2019). Optimal dynamic capital budgeting. The Review of Economic Studies, 86(4), 1747-1778. https://doi.org/10.1093/restud/rdy043
Pascual, N., Sison, A., Gerardo, B., & Medina, R. (2018). Calculating Internal Rate of Return (IRR) in Practice using Improved Newton-Raphson Algorithm. Philippine Computing Journal, 13(2), 17-21.
Pettinger, R., & Pettinger, R. (2020). The Foundations of Management. The Socio-Economic Foundations of Sustainable Business: Managing in the Fourth Industrial Revolution, 1-14.
Xie, M. (2021). Research on the modified internal rate of return. Turkish Journal of Computer and Mathematics Education (TURCOMAT), 12(11), 4087-4090.
Yard, S. (2020). Developments of the payback method. International journal of production economics, 67(2), 155-167. https://doi.org/10.1016/S0925-5273(00)00003-7