The following project is related to the budgeted decision on the basis of appraisal techniques. The project should be selecting according to the analysis of profitability by appraisal techniques (Advanced investment appraisal, 2013). The most profitable and appropriate technique should be selected for the project analysis for relevant conclusion. The project requires the huge money, so proper analysis is necessary for the project, to evaluate the most beneficial project for the organization (Peterson and Series, 2004). As stakeholders interest are affected by the decision of the project, so the report of the analysis should be relevant and reliable for them that is will be beneficial or it will provide the advantage to them. The selected project should not be prejudice to the interest of the company.
The selection of the project is done on the basis of inflow by the project and estimated cost for the project. The expected budget should be prepared for the analysis of various projects; the analysis of project should comparable to select the most appropriate project for the organization (Baker and English, 2011). The analysis of the project will answer the question put up by the stakeholders of the organization which tell about, that level of extension of project? New production facilities by the firm? Expansion is other countries? Which type of investment is done and the benefits of the following project to the stakeholders of the organization.
Capital budgeting refers to the process of financial planning by the organization to determine the benefits of the investment done by the company. In includes the process of allocating the resources of organizations to increase the wealth of the shareholders of the organization. There are various techniques available for the process are- accounting rate of return, payback period, net present value, profitability index, internal rate of return, modified internal rate of return, equivalent annuity of the project and real options valuation. The following methods calculate the incremental cash flows from each of the available project. These techniques are based on the accounting rules and regulations. These methods consider time value of money for the proper evaluation of the project.
Techniques available of capital budgeting
Payback Period Method
It is the methodology through which analyst can find out the duration in which investment made on the part of business unit is recovered. The techniques has high acceptance due to its simple approach. It suggests investment in project that is generating cash flows in shorter duration of time (Gotze, 2008). Another reason due to which methodology has achieved huge acceptance is estimation of number of years usually seems to be understood by each and every individual. It assists in quick decision making by fast evaluation of projects under consideration. The evaluation of projects with the help of payback period generally does not involve large number of proficient employees and tedious financial analysis.
simple approach in deciding profitable investment option (Project and Investment Appraisal for Sustainable Value Creation, 2013). However, the technique is efficient in testing the feasibility of project it has certain limitations. One of the basic disadvantages is that it does not consider time value of money and neither has it taken into consideration the fact that there is certain cost associated with the amount of investment. Another aspect is that it does not generates clear picture of return generated; since it just emphasizes on duration taken to recover initial investment. Nevertheless, the technique is widely applicable due to its simplicity involved in the approach.
Net Present Value
The methodology is gem of capital budgeting techniques. This method overcomes all the limitations of other three methods. Under the net present value technique all future cash flows are discounted at cost of capital; this in turn generates present value of all cash flows and Total present value. Initial investment made than is subtracted from Total present value so as to measure Net Present value. The methodology suggests investment in the following manner:
- If NPV is positive or greater than 1; then project should be accepted.
- If NPV is negative or less than 1; then project should be reject.
- If NPV = zero. Then technique is indifferent towards investment.
If evaluation is made for comparison of two projects. Then project with higher NPV is suggested for investment purpose.
The methodology takes into account time value of money. It is based on the fact that with the passage of time value of money goes on decreasing. In addition it also takes into account the cost of capital since every amount spent in project is acquired at certain cost. In addition; it generates the present value by discounting cash flows at realistic rate of return. The methodology has a drawback that it does not include sense of flexibility for evaluation purpose. It calculates discounted cash flows at same rate during entire life (Project and Investment Appraisal for Sustainable Value Creation, 2013). However, due to its high level of significance and capacity to overcome all limitations it is considered as most suitable option for justifying investment option.
Internal rate of Return
The internal rate of return of return measures the rate at which NPV equates zero. It aims at measuring the return generated by project during its entire life. The methodology has gained significance in modern era (Wang, Haslam, and Marston, 2011). This is due to the reason that it takes into consideration time value of money and at the same time measures rate of return generated.
It is recommended to the company to use the techniques of the capital budgeting in choosing the appropriate project (Advanced investment appraisal, 2013). The capital budgeting helps organization to achieve the objective of financial planning and allocation of resources into the investments. If time value of money is not considered in the project then payback period and accounting rate of return is the appropriate technique for the selection of the project. If the time value of money is to be considered in the project net present value method and internal rate of return will be appropriate for the selection of the project.
It the profit oriented project are not available with the organization, and then they should return the funds to the shareholders, to save to cost of capital, or negative returns from the project (Baker and English, 2011). The selection of the project should be done on the basis of available funds, if funds are not appropriate for the project, and then that project should be avoided. The capital structure of the organization should be considered while selection of the project.
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