Finance

Assessing Capital Projects

Apple Inc.

Apple incorporated is a company that has invested heavily in capital projects. The company’s budget for capital structure for the financial year ended 2017 is $16 billion. The capital projects that Apple incorporated is involved in including an investment in retail store renovations, the building of new Apple Campus, product tooling and facility and manufacturing equipment. The company has the projects mentioned above that it is currently involved. The decision on the capital expenditures the company will be involved is determined using capital budgeting techniques.

There various capital budgeting skills. The methods include IRR, NPV, payback, and ARR. IRR is Internal Rate of Return (Bodie, 2013). The method determines the rate of return on a project. The IRR has advantages. The method helps in the determination of whether a capital project will increase the value of a company. The method considers the cash flows of a project, the time value of money and determines the risks associated with future cash flow (Weygandt, Kimmel & Kieso, 2015). 

The IRR method, however, has some limitations. The method requires that an estimate is made of the cost of capital. The decision can be done only with the help of the cost of capital. The IRR may not provide the right decision on the project that will maximize the value of the project. The method cannot be used when comparison mutually exclusive projects. The method cannot also be used where the choice has to be made taking into account the need for capital rationing (Weygandt, Kimmel & Kieso, 2015).

The IRR method is also not suitable where the cash flows from the life of the project change from negative to positive values frequently. The method is also not suitable where there are non-normal cashflows. The non—normal cash flows result in multiple IRR’s. The computations involved in the calculations are very complicated.

The Net Present Value (NPV), is the sum of the present value of all the cash flows. The cash flows are discounted to determine its present value (Weygandt, Kimmel & Kieso, 2015). The method has a variety of benefits. The method is preferred because it recognizes the time value of money. The method also considers all the cash flows that are related to the life of the project. The method helps in determining the project that brings value to the company. It can help in determining the investment that will determine the value of the firm. The method also considers the risks associated with the future cash flows.

The NPV method also has limitations. The method, however, requires an estimate of the cost of capital. The cost of capital cannot be easily estimated, and the method of estimating is a difficult concept. The NPV expresses the solution in dollars and not as a percentage. The method does not take into consideration the size of the project. The method is also not ideal where the projects have different investment amounts.

In some cases, the results from the IRR method and the NPV method are conflicting. One cannot determine the technique that shows the best decision. One method can show that there is no need to take the project while the other method shows that the project should be accepted. There are conflicting results because of the size of the project as well as the timing of the cash flows. In such a case, the NPV is the one that should be used (Sultana, 2015).

The payback period is a method that determines the period it takes to recover the original cash outlay (Fabozzi & Drake, 2009). The method is determined by dividing the initial cash outlay by the annual cash flows. The method has various benefits. The method helps in determining the project that will have a shorter payback period. The project that has shorter periods are less risky, and thus the company has a guarantee against loss. The method also has an insight on the liquidity of the project.

The method has some limitations. The payback period does not take into consideration the cash flows of the project after the initial cash flow is paid back (Weygandt, Kimmel & Kieso, 2015). The method is also not ideal for determining the profitability of the project as it does not take into consideration all the cash flows associated with the project. The method does not help in determining whether a project will increase the value of a firm. The method does not take into consideration the time value of money and the risk associated with the future cash flows.

The accounting rate of return (ARR), is used to determine the profitabilities of the investment. The average investment divides the average profit from the project. The method has some advantages such as its simple to understand. It uses accounting data to calculate.

The method however has some limitations. The method uses profits instead of the cash flows associated with the project (Weygandt, Kimmel & Kieso, 2015). The method does not take into consideration the time value of money. The profits that occur at different times are value the same. The project does not also consider the life of the project. The method does not also consider that the profit that can be reinvested.

References

Bodie, Z. (2013). Investments. McGraw-Hill.

Fabozzi, F. J., & Drake, P. P. (2009). Capital Budgeting Techniques. Handbook of Finance.

Sultana, N. (2015). Conflicting Result between NPV and IRR: Which one is better? International Journal of Research in Business and Technology, 7(1), 873-877.

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2015). Financial & Managerial Accounting. John Wiley & Sons.