A Precursor to Chapter 12
Chapter 12 which delves into “allocating capital and corporate strategy” is distinct neither for its complexity nor for its introduction of dramatic new concepts. Rather it is an attempt to acquaint the student with advanced Capital Budgeting Techniques that negates some of deficiencies that dwell within the traditional capital budgeting methods. It was painfully evident during the our question and answer session that even though students have encountered an array of traditional methods during their academic pursuits, they were hampered by an inability to define, distinguish and methodically state the salient features of the traditional methods of capital budgeting. Hence I thought it would be prudent to list some of the concepts that should be reviewed before tackling the more advanced material in chapter 12.
Payback Period – is a term that has application in both the business and economics arenas and is used to characterize the time duration required to repay an original investment. Payback = days/weeks/months x initial investment / total cash received. The greatest advantage of this methodology is the relative ease with which it can be comprehended. It is however handicapped by its failure to properly account for time value of money, risk, financing and opportunity cost.
Hurdle Rate – can be classified as the minimum rate of return that is required for a company to pursue a project. Hurdle rate is also analogous with other terms such as cutoff rate, benchmark and cost of capital. The major drawback of using this criterion is that profitable, feasible projects could be turned down and a large hurdle rate requirement will lead to a marked preference for short term projects over long term projects.
Cost benefit Analysis – is an informal medium of decision making. It evaluates proposals for project by weighing the total cost against the benefits that can be accrued from the undertaking. Governments are usually proponents of the cost benefit methods and use it as a gauge to measure the desirability of new undertakings.
Profitability Index – PV of future cash flows/PV of initial investment. PI is an instrument that that enables an investor to quantify the amount of value that each unit of investment generates. If PI is greater than 1 then the project can be accepted, if it is less than one it should be rejected because a value of less than one effectively indicates that the PV of the project would be less than the investment
Net Present Value – “is the present value of an investments future net cash flows minus the initial investment.” Projects that have a positive NPV can be deemed as feasible and projects that are burdened with a negative NPV should be rejected.
Internal Rate of Return – is another tool in the arsenal of investors as they debate investment decisions. As opposed to NPV which highlights value, IRR proclaims the efficiency or quality of a project. IRR is the discount rate that converts the NPV of an Investment to zero. If the IRR is larger than the cost of capital then the project can be deemed as a value adding proposition.
Modified IRR – As the name implies the Modified IRR is an enhancement of the IRR. IRR does not take into account the potential for positive cash flows to be reinvested. MIRR rectifies this flaw by inferring that all positive cash flows are reinvested for the entire lifespan of the project, while the negative cash flows are discounted and added back to the original investment outlay.
Works Cited
"COST-BENIFIT ANALYSIS." WIKIPEDIA. 13 Nov. 2008. 30 Nov. 2008 <http://en.wikipedia.org/wiki/cost-benefit_analysis>.
"HURDLE RATE." WIKIPEDIA. 20 Sept. 2008. 22 Nov. 2008 <http://en.wikipedia.org/wiki/hurdle_rate>.
"INTERNAL RATE OF RETURN." WIKIPEDIA. 21 Nov. 2008. 30 Nov. 2008 <http://en.wikipedia.org/wiki/internal_rate_of_return>.
"MODIFIED INTERNAL RATE OF RETURN." WIKIPEDIA. 13 Sept. 2008. 22 Nov. 2008 <http://en.wikipedia.org/wiki/modified_internal_rate_of_return>.
"NET PRESENT VALUE." WIKIPEDIA. 21 Nov. 2008. 22 Nov. 2008 <http://en.wikipedia.org/wiki/net_present_value>.
"PAYBACK PERIOD." WIKIPEDIA. 2 Sept. 2008. 20 Nov. 2008 <http://en.wikipedia.org/wiki/payback_period>.
"PROFITABILITY INDEX." WIKIPEDIA. 12 Oct. 2008. 22 Nov. 2008 <http://en.wikipedia.org/wiki/profitability_index>.
