Capital budgeting involves long-term planning of proposed capital. It is four stages process involving identification, generation, evaluation of alternatives, selection, authorization, implementing, and control. The higher the risk, the higher the rate of return required. Approaches to recognizing risk in capital-budgeting reducing the required payback period time, increasing required rate of return, adjusting estimated cash inflows, performing sensitivity analysis, and estimating probability analysis for future distribution.
Non financial based model NPV and IRR may ignore intangible benefits and may be inadequate for evaluating investments involving non-financial, qualitative and strategic factors.
YEAR(EOY)
OUTFLOW OF CASH
ACCUMULATED CASH FLOW
PAY BACK PERIOD(YEAR)
0
250,000
(250,000)
0
1
30,000
220,000
1
2
60,000
160,000
2
3
90,000
70,000
3
4
90,000
0
3.78
5
70,000
6
60000+scrap value(50,000)
(a)PAY BACK PERIOD (PB):
Here, the project will last for 6years
Installation cost ……………………………… £250,000
Scrap value…………………………………………£50,000
DISCOUNTED PAYBACK PERIOD = YEAR BEFORE FULL RECOVERY + (UNRECOVERED COST AT THE START OF THE YEAR/ DISCOUNTED CASHFLOW DURING THE YEAR)
(b) NET PRESENT VALUE METHOD
Required rate of return = 9%
PVIF = (1+i) ^n
i=9%
EOY
CASH FLOW
PVIF 9%
PVCF
0
(250,000)
1
(250,000)
1
30,000
0.917
27,510
2
60,000
0.842
50,520
3
90,000
0.772
69,480
4
90,000
0.708
63,720
5
70,000
0.650
45,500
6
60000+scrap value(50,000)
0.596
65,560
NPV 72,290
Net Present Value Index (NPVI) = NPV / amount of cash flow
= 72,290/ 250,000
= 0.28916
(c)INTERNAL RATE OF RETURN:
i=16%
EOY
CF
PVIF 16%
PVCF
0
(250,000)
1
(250,000)
1
30,000
0.862
25,860
2
60,000
0.743
44,580
3
90,000
0.641
57,690
4
90,000
0.552
49,680
5
70,000
0.476
33,320
6
60000+scrap value(50,000)
0.410
45,100
NPV
6,230
i=17%
EOY
CF
PVIF 17%
PVCF
0
(250,000)
1
(250,000)
1
30,000
0.855
25,650
2
60,000
0.731
43,860
3
90,000
0.624
56,160
4
90,000
0.533
47,970
5
70,000
0.456
31,920
6
60000+scrap value(50,000)
0.391
43,010
NPV
(1,430)
INTERNAL RATE OF RETURN:
Here,
LR = Low Return LR= 16%
HR = High Return HR=17%
LN= Low NPV LN=£(1,430)
HN = High NPV HN=£6230
IRR= LR + LN / (LN_HN) * (HR-LR)
= 16% + {1,430 / (1430 + 6,230)} * (17% - 16 %)
=16% + 0.19%
= 16.19%
STRENGTH AND WEAKNESSE:
Payback period (PB) Method:
Strengths:
The Payback period method is the easiest way to make decision project selection. It is simple and quick to use.
Payback period is an indicator of liquidity and risk for project. The shorter the payback period, the greater is the liquidity because the project generates cash influence more quickly to recover the initial investment.
Weaknesses:
Payback ignores the timing of cash flows within the payback period. The failure to consider the time value of money understands the true payback period.
It neglects the expected cash flows that occurred beyond the payback period.
Payback does not measure the profitability, only the speed of recovering the initial statement.
It biased against the long-term investment
Net Present Value (NPV):
Strength:
NPV method shows the time value of money
It provides the theoretically correct accept result
It reflect on the total profit over the lifetime of the project
It is useful to chose the mutual exclusive project
It is straightforward to calculate
Weaknesses:
Calculate the discount rate is complicated
Improper NPV give the wrong result
Require the knowledge of finance. So some people do not understand the measure
Internal Rate of Return (IRR):
Strengths:
Considers all relevant cash flows of the invest of the project
Time value of money approach
Widely used by practitioners and easily understand
Weaknesses:
Assumes reinvestment of proceeds at the internal rate of return
Estimates may be difficult to develop
Can generate multiple rate of return.
RISK:
Risk is uncertainty, or the perception of uncertainty.. The following are given by some risk arise in foreign developing country where the labor is cheap but economic and political condition is not good.
A part from the general risks associated with any kind of investment such as market risk and credit risk investing out-side a country's national frontiers entails more and different kinds of risk.
These additional risks which include currency risk and country risk arise as a result of the nature of the foreign market.
COUNTRY RISK: Country risk includes the political risk and economical risk(Moosa).
Political risk: Political risks are those risk which arise from potential impact of government, legislative, judicial and political acts. The following political risk that preoccupy investors(Delman):
Convertibility and transferability: monetary regulation may can limit the extent to which currency (capital, investment, profits, royalties or other monetary benefits) can be converted into foreign currency and to which can be transferred out of country.
Devaluation: certain countries govern conversion of the local currency into foreign currency fixing the rate exchange. Though it may by influence by macro and micro economics, revaluation is a political decisions. Though the economic conditions is not good means rate of money may be low rate
Expropriation, confiscation and nationalization: The government of the country may decide to alter the way; assets are owned or managed the right in assets. May be needs to pay the compensation for the seized assets.
Political violence: political decisions may result in destruction, removal, or political motivated acts.
Failure to provide or revocation of licenses, approvals and consents: Investment in infrastructure requires a number of permission from political entities from different levels. If the political situation is unstable in this situation it takes to get result.
Regulatory decisions: secondary legislative power is delegated to regulatory bodies. Risk arises in relation to the discretion granted to regulations over issues, key the investment in particular policies.
Changes in laws or tax: in unbalance political situation law changes over time. May be pass a new law effect on the projects
Economical Risk: Economical risk factor includes current and potential state of economy. It includes the demand of the products of that country. The demand is strongly influence by the country's economic situation. Lower income leads to lower demand higher income leads to higher demand. So the unstable developing country's demand might be low. State of the country's economy depends on inflation rate, interest's rates and exchange rates. The problem of the inflation, it affects the purchasing power and exchange and interest rates related to capital flows.
COMMUNICATION SOURSE AND SKILLS:
Effective communication is required for send out directives, making cooperation and team spirit, optimising performance and satisfaction, and avoiding and solving problems. Communication conduit can be formal or informal and flow in several directions. Many people think that presenting in front of PowerPoint is called the presentation but in business environment every conversation is presentation. To be successful professional communication is the way to present the idea and skills. Many business problems could be solved by communicating with internally and externally. People communicate each other to resolve many problems, to know the environment and the cultures. Effective communication is very important for the business. Communication needs to be employee to employer in workplace. Poor communication brings the hazard ness in organization.
The communication component could be the sender, the receiver, communication media, message and feedback. The communication process includes the several steps.
Sender: the person who send the message.
Encode: translate the message for transmitting
Media: the massage transmit one person to another to need the proper channel
Decode: decode the message for the receiver
Receiver: Who get the message
Feedback: the response to send the sender
Communications in organizations could be verbal or lateral, formal or informal, vertical and horizontal. Formal communication occurred within organization by downward and upward communication. Downward communication is used by the higher level of management to achieve the organizational goals and provide information, procedure and policies and get the feedback. And upward communication is related to get information from the lower level information, current situation, feedback, and upgrade the employee's progress. Informal communication channels are informally communicated with others to gather information idea. Social gathering have established to be an effective and informal method of communication between employees and managers.
Communication is occurred by transmitter and receiver. When message sent to the receiver this way is called the communication. The way of communication could be:
Interpersonal communication
Intrapersonal communication
Intergroup communication
Mass communication
A message is sent more accurately by:
Increase the clarity of message: A sender can eliminate the barriers by credible message. By ensuring the feedback from the receiver.
Develop credibility: develop credibility by trustworthy of both sender and receiver.
Communicate ethically: It may be help reliable of the message by altering information. It provides the freedom of choice.
Achieve feedback: verbal feedback gives the clearity facts, feeling and needs.
The following way a message more accurately received:
By asking question
Listening Read non verbal communication clue
Improve cross-cultural communication
