Maryam Aman

 Table of Contents 1.Capital Budgeting1 2.Difference b/w Independent and Mutually Exclusive Projects1 Independent Projects1 Mutually Exclusive Projects1 3.Payback Period2 Payback for Franchise L:2 4.Rationale of Payback Method2 Selection of Franchise based on Payback Criterion3 5.Difference b/w Regular and Discounted Payback Periods3 Calculating Discounted Payback for Franchise L3 6.Disadvantages of Discounted Payback4 7.Net Present Value (NPV)4 Franchise L’s NPV5 Franchise S’s NPV5 8.Rationale for NPV5 9.Change in NPV5 10.Internal Rate of return (IRR)5 IRR of Franchise L6 IRR of Franchise S6 11.Logic behind IRR6 12.Change in IRR in case of change in Capital Cost6 13.Problem with extra-large Capital Budget7 Bibliography8 1. Capital Budgeting Capital budgeting, nowadays, plays an essential part in any business’s monetarist management strategies. Capital budgeting can be defined as a procedure that assesses and chooses a long-term investment that is in line with company’s aim of make the most of the owner’s wealth. Usually, every company or individual that adopts this procedure needs to take all the essential steps to make sure that their selected decision-making criteria is supporting the company’s approach and improves their competitive advantage over their rivals. The understanding that an industry influences its competitive advantage based its resources and the way it carry out decisions related to the utilization of its assets, like monetary resources requires the manager to make an informed decision. Managers all around the globe have established both, non-systematic and systematic methods for handling the capital budgeting processes in their business environment. Moreover, these days, most managerial decisions are commonly but not every time grounded on an up-to-date information and research (Brijlal, & Quesada, 2009). 2. Difference b/w a Mutually Exclusive and Independent Project Independent Project An independent project is the one whose cash-flow has no influence whatsoever on rejection or acceptance of other business projects can be characterised as an independent project. Mutually Exclusive Project Mutually exclusive projects are the ones from which, at most, only one project will be selected and accepted. As far as mutually exclusive projects are concerned, cash-flows of one project could be unfavourably affected by reception of another venture or project. However, in a mutually exclusive project, the project aims to complete one single assignment. That is why; no such projects can be accepted at the same time. In order to choose between two or more projects, factors like preliminary investment, strategic significance of the venture and time period necessary for completion of the project are considered. Capital budgeting techniques are usually used for making such decisions. Net present value (NPV) is mostly used while deciding whether or not to accept mutually exclusive projects as it is more realistic and gives a realistic assumption of re-investment rate (Arshad, 2012). 3. Payback Period Payback period can be defined as the amount of time in which preliminary cash out-flow of any investment is most likely expected to be redeemed from cash in-flows caused by the initial investment. Payback period is advantageous in terms of its simple method of calculation. Additionally, payback period can help in calculating the extent of risk intrinsic in a venture or project. As cash flows that ensue far along in a venture's lifetime are thought to be more indeterminate, thee payback period offers a suggestion of how definite the project’s cash in-flows actually are (Ardalan, 2012). Payback for Franchise L: Year Expected net cash-flow Franchise L Expected net cash flow Franchise S 0 ( $100 ) ( $100 - Initial investment: $300,000 If it is assumed that the cash-flows take place equally over the entire year, the investments are then recuperated; 30/80 = 0.375 ≈ 0.4 in year 3. As a result, paybackL = 2.4 years. Correspondingly, paybackS = 1.6 years. $100 venture of Franchise L has not been recuperated by the end of second year, but the cost that is recovered is far greater by the end of third year. As a result, the retrieval period is between 2nd and 3rd year. 4. Rationale of Payback Method Payback method is advantageous in terms of its simple method of calculation. Additionally, payback period can help in calculating the extent of risk intrinsic in a venture or project. As cash flows that ensue far along in a venture's lifetime are thought to be more indeterminate, thee payback period offers a suggestion of how definite the project’s cash in-flows actually are. One shortcoming, however, of payback method can be identified as its lack of taking into account the cash flows later the payback period; therefore, it cannot be termed as a measure of the cost-effectiveness of the investment scheme (Ardalan, 2012). Selection of Franchise based on Payback Criterion Payback period signifies a breakeven analysis; as payback of two years is needed, Franchise S can be acceptable but Franchise L cannot be accepted irrespective of being mutually exclusive or independent. 5. Difference b/w Regular and Discounted Payback Periods Payback can be defined as the total time that is required for the net cash cost-savings/cash-revenue of a venture to remuneration the preliminary investment. The discounted payback, on the other hand, is known as the total time required for the discounted cost savings/net cash revenue of a venture to reimburse the preliminary investment. Additionally, the discounted payback-period utilizes the venture's budget of investment to discount the estimated cash flow (Ardalan, 2012). Calculating Discounted Payback for Franchise L The calculations of discounted payback periods are like the calculating the regular pay-back time, excepting the calculations must be based on the new calculations of discounted cash-flow. Moreover, Franchise L has a budget of capital of 10%. Estimated Net Cash Flow Year Initial Discounted Cash flows Cumulated 0 $100 $100 $100 - Discounted Payback L = 2 + ($41.32/$60.11) = 2.7 years Regular payback = 2.4 years 6. Disadvantages of Discounted Payback The first and foremost disadvantage of discounted payback period is that time value of money is not deliberated in this method. This means that it does not matter the year in which the cash flow is received because it will be given the weight similar to the first year of cash flow. That is why, it can be assumed that this method overstates the required time in which the initial investment will be recovered. Additionally, these methods do not take into consideration the cash flow after the payback periods. In case the project continues even after the payback time, the cash flows generated by the venture after the preliminary payback time is not taken into consideration in the overall payback period (Ardalan, 2012). Since payback period does not take into consideration the time value of money and capital budgeting requires taking into consideration the time value of money, discounted payback period is not as beneficial in capital budgeting as NPV (Ardalan, 2012). 7. Net Present Value The total sum of all the cash flows of future that determines the present value is known as the net present-value. Outflows and inflows are included in the cash flows on a discounted percentage in any project. In case the project displays a positive outcome then the project is acknowledged if the net present value illustrates more worth as compared to the project’s preliminary cost. Net present value can be calculated as follows: NPV = Cash inflows – Cash outflows NPV = - CF0+ (CF1/ (1+i)1) + (CF2/ (1+i)2) +(CF3/ (1+i)3) Or NPV = Cash outflows are the expenditures of the investment. Thus, the NPV of any given project is the total sum of present value of its total cash flows including, out flows and inflows, reduced at rate constant with the venture’s risk (Arshad, 2012). Franchise L’s NPV NPVL = . NPVL = $18.79 Franchise S’s NPV NPVS = . NPVS = $ 19.98 8. Rationale for NPV NPV is used for capital budgeting technique so as to compare the benefits and costs of a proposed investment or project. NPV principally tries to categorise the most feasible investment prospects by equating the present worth of future cash-flows of different projects. The justification for the net present value technique is that it emphases on the boosting of capital for shareholders or industry owners. Furthermore, if NPV of a project equals $0, this means the project produces enough cash flows and is able to recuperate the initial cost of investment and if NPV has a positive value, excessive cash flow is produced (Arshad, 2012). As independent projects, both the initiatives can be accepted since both have a positive value of NPV but if taken as mutually exclusive projects, than project S should be taken as it has a higher value of NPV. 9. Change in NPV Since net present value uses the initial cost of the project, its value will change if initial cost of the capital is changed. 10. Internal Rate of return (IRR) If a project demonstrates positive results then the project can be established as its net present value demonstrates more worth than its preliminary cost. NPV terms the worth of an investment in terms of currency but Internal Rate of Return demonstrates that total in terms percentage. IRR can be termed as the “Internal Rate of Return” that is mostly used for concluding the rate of return of a project. IRR gives the estimate of return on a project in percentage. It is essentially founded on the concept of net present value stating that internal rate of return is essentially the capital budget method which in fact associates the NPV to the preliminary cost or investment (Arshad, 2012). IRR: = $0 = NPV IRR of Franchise L $ 0.06 ≈ $0 IRRL = 18.1% is the discounted rate. As a result, IRRL ≈ 18.1% IRR of Franchise S For franchise S, IRRS ≈ 23.6% 11. Logic behind IRR IRR calculates profitability of a project as the rate of return. So, in case IRR of a project is equal to its initial cost of capital, at that point the cash flows of the project are just enough to provide stakeholders with their prerequisite rate of return on the project. If an IRR is greater than r, this suggests a financial profit, which accumulates to the business's stakeholders, if the IRR less than r, this point to a financial loss, implying that the project wont earn sufficient to recover its budget of investment. IRR of ventures are equated to the cost of investment, or else hurdle rates (Arshad, 2012). As far as hurdle rate of franchises S and L is concerned, they both happen to have a hurdle rate of 10%, and both franchises have IRR more than their hurdle rates, both of these franchises can be accepted in case of independent projects. Conversely, if both the franchises are said to be mutually exclusive, franchise S have to be selected as it has a high rate of return. 12. Change in IRR in case of change in Capital Cost IRRs are not dependent on the initial cost of capital of the project. As a result, neither IRRL nor IRRS would be changed if value of r is changed. On the other hand, the suitability of the franchises might change. In such a case, franchise L would most likely be overruled if value of r is above 18.1%, and franchise S will also be overruled if value of r is more than 23.6%. 13. Problem with extra-large Capital Budget As there are numerous projects with positive NPV, this means there is ample opportunities to consider for capital investment. But since the capital budget is extra-large, the owner of the capital can start multiple projects with the budget at hand but there is a high risk involved if multiple projects are started. Therefore, NPV and IRR of each project should be calculated and analysed before taking any decision. Sunk cost, opportunity cost, inflation, externalities, tax effects and lifetime cost of each project would be required to calculate, not to mention its environment and socio-economic effects. Opportunity cost, lifetime maintenance costs would also need to be calculated. All these considerations would make it quite difficult to initiate more than one projects at the same time (Arshad, 2012). Bibliography Ardalan, K. (2012). Payback Period and NPV: Their Different Cash Flows. Journal Of Economics And Finance Education, 11(2), 12-15. Arshad, A. (2012). Net Present Value is better than Internal Rate of Return. Interdisciplinary Journal of Contemporary Research in Business, 4(8), 34. Brijlal, P., & Quesada, L. (2009). The Use Of Capital Budgeting Techniques In Businesses: A Perspective From The Western Cape. The Journal Of Applied Business Research, 25(4), 37.