Response to Classmates Discussions
kingstonman41
Week4Discussion1ClassmatesResponse.docxWeek 4 - Discussion Forum
Guided Response: Respond to at least two of your fellow students’ or instructor posts in a substantive manner and provide information or concepts that they may not have considered. Each response should have a minimum of 100 words and be respectful of others’ opinions and beliefs that differ from your own. Support your position by using information from the week’s readings. You are encouraged to post your required replies earlier in the week to promote more meaningful and interactive discourse in this discussion forum.
There are three of my classmates with discussion that needs to be responded to. Their name is Lisa Schreiner , Jamie Choate , and Madison Dern
Lisa Schreiner
FridayJul 17 at 4:42pm
Capital budgeting techniques vary from business to business, including each organizations method of best practice and considering levels of threshold when weighing the results. The three primary methods of capital budgeting include the payback method, net present value (NPV), and internal rate of return (IRR) (Block et al., 2019).
The payback method calculates how long it takes for a company to recover its investment in revenue. One advantage to this method is that it is simple to calculate, interpret, and decide upon, but the longer the recovery period, the riskier the investment becomes to reach a breakeven point of cash inflows relative to outflows (McIntosh, 2017). The payback method allows the company to screen projects as an initial pass, weeding out those which do not meet the organizations threshold criteria reducing risk exposure from unprofitable options (McIntosh, 2017). Disadvantages of the payback method include its lack of considering the change in value due to inflation and deflation, and this method does not account for cash inflows or outflows following the breakeven point (McIntosh, 2017). Generally, small businesses use the payback method.
The NPV method considers the value of all project cash inflows and outflows when evaluating profitability of the investment. Advantages include the ability to measure profit on the project and minimizing risk through the discount rate application of all cash aspects (Borad, 2019). Disadvantages include a miss in estimating initial project costs, including any upfront expenses prior to the presenting the project for approval, and determining the appropriate discount rates to apply in the profitability calculation (Borad, 2019). Any type of company can use the NPV method, but due to the extensive analysis around gathering the necessary aspects and measuring impact, large organizations would be the significant users.
The IRR method measures profitability by calculating the rate of return on an investment. Advantages to IRR are it includes all cash flows in the evaluation up to the value of the capital investment and it is simple to understand and apply (Lanctot, 2019). Disadvantages include it neglects considering future cash flow profits generated from the project and it does not distinguish between sizes of projects where a small project could achieve a higher IRR (Lanctot, 2019). Risk is losing future profit cash flow is evident with a long term project. The IRR is valuable to small business due to its ease in calculation and interpretation.
A real life example of a company applying a capital budgeting decision is Centage. According to Banham (2017), “In making investments in cloud-based applications, there’s no need to take into account each one’s IRR or NPV, Orlando says, “just the ROI” (p. 30). This is an example of considering the type of project investment relative to the primary source of revenue, and applying the appropriate method the organization is comfortable with.
References
Banham, R. (2017, October). The best path forward: CFOs blend new and old techniques in a quest for capital spending solutions that allow more flexibility. CFO, 33(8), 28–33. https://www.cfo.com/cfo-magazine (Links to an external site.)
Block, S. B., Hirt, G. A., & Danielsen, B. R. (2019). Foundations of financial management (17th ed.). https://www.vitalsource.com (Links to an external site.)
Borad, S. B. (2019, August 12). Advantages and Disadvantages of NPV. https://efinancemanagement.com/investment-decisions/advantages-and-disadvantages-of-npv (Links to an external site.)
Lanctot, P. (2019, March 01). The Advantages and Disadvantages of the Internal Rate of Return Method. https://smallbusiness.chron.com/advantages-disadvantages-internal-rate-return-method-60935.html (Links to an external site.)
McIntosh, K. A. (2017, March 28). Advantages & Disadvantages of Payback Periods. https://www.sapling.com/8609065/advantages-disadvantages-payback-periods
Jamie Choate
YesterdayJul 21 at 1:55pm
Capital budgeting can be costly if not done correctly and money is not invested in the right areas to provide adequate return on investment. There are different methods that companies can use to assist in ranking and prioritizing proposals for competing capital projects. These methods are the payback method, the net present value (NPV) method, and the internal rate of return (IRR) method. One must also focus on risks or the variability of possible outcomes that can come from a given investment. Risk can be measured in loss as well as in uncertainty (Block, Hirt, & Danielsen, 2019).
The payback method is used to determine the time required to recoup the initial investment. A short payback period is preferred because it indicates that the investment will pay for itself within a shorter period of time (Pinkasovitch, 2019). Most companies that use this method are smaller companies, companies that are struggling with liquidity issues, or companies looking for rapid payback such as firms in industries characterized by rapid technological developments (Block, Hirt, & Danielsen, 2019). The payback method is also a good method for risk adverse companies. Since risk increases overtime, estimating the shortest payback period will ensure project value.
Advantages:
· Simple to calculate
· Can be used when a company suffers from liquidity issues and can only focus on one large investment at a time and need payback quicker to move forward (Pinkasovitch, 2019)
Disadvantages:
· Does not account for the time value of money
· Ignores cash flow towards the end of project life (Pinkasovitch, 2019)
· Fails to discern the optimum or most economic solution since it concentrates only on the initial years of investment (Block, Hirt, & Danielsen, 2019)
The net present value method (NPV) is the sum of the present values of all outflows and inflows related to a project. The inflows and outflows are normally discounted using the WACC method (Block, Hirt, & Danielsen, 2019). This is the most intuitive and accurate valuation approach (Pinkasovitch, 2019). The NPV rule states that all projects that have a positive NPV will be accepted and those with a negative NPV should be rejected (Pinkasovitch). The NPV method is used by several companies and is known as the preferred method. When projects carry different risks, companies may use a risk adjusted discount rate when estimating the NPV. The outcomes may change based on a result of adjusting the discount rate to reflect risks. When the discount rate is adjusted to reflect risk, the rate increases resulting in a lower present value (Gorton, 2016).
Advantages:
· Provides a direct measure of added profitability
· Provides an ability to compare multiple mutually exclusive projects simultaneously (Pinkasovitch, 2019).
Disadvantages:
· Requires a company to make assumptions around future cash flows
· Not applicable when comparing projects that have different investment amounts (Woodruff, 2019).
Then internal rate of return (IRR) method measures the profitability of investments as a return percentage (Block, Hirt, & Danielsen, 2019). The IRR on an investment is the “rate of return” that makes the NPV of the project equal to zero (Block, Hirt, & Danielsen, 2019). When a project has an IRR greater than the WACC suggests that the project is profitable, however if lower it is just the opposite (Pinkasovitch, 2019). The IRR is used by companies that are not comparing mutually exclusive projects.
Advantages:
· Easy to compute
· Provides a benchmark figure for every project that can be assessed in reference to a company’s capital structure (Pinkasovitch, 2019).
Disadvantages:
· Does not provide a true value that a project will bring overall to the firm
· Does not allow for appropriate comparison of mutually exclusive projects (Pinkasovitch, 2019).
All companies regardless of the method they choose to use should evaluate all possible combinations of projects to determine which project not only provides the best value to the company but that also provides the best trade off between risk and return (Block, Hirt, & Danielsen, 2019). They must also look at the overall risk to the company and not just the risk to one project.
All companies have a process they follow for determining capital project funding. Wal-Mart is one company that uses the NPV and IRR methods. Their goal is to minimize the investment cost per square foot of retail space with the aim of faster payback on the investment (Soni, 2015). Concentrating on Neighborhood Markets and smaller stores in locations with greater population densities created the highest NPV and IRR (Soni, 2015). The smaller firms also resulted in quicker paybacks from the investments.
References:
Block, S. B., Hirt, G. A., & Danielsen, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com
Gorton, D. (2016, August 31). A Guide on the Risk-Adjusted Discount Rate. Retrieved from https://www.investopedia.com/articles/budgeting-savings/083116/guide-riskadjusted-discount-rate.asp
Pinkasovitch, A. (2019, June 25). Investopedia. An Introduction to Capital Budgeting. Retrieved from https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp
Soni, P. (2015, February 18). Walmart’s Capital Strategy – Smaller Stores And Supercenters. Retrieved from https://marketrealist.com/2015/02/walmarts-capital-strategy-smaller-stores-supercenters/
Woodruff, J. (2019, January 25). Chron. Advantages & Disadvantages of Net Present Value in Project Selection. Retrieved from https://smallbusiness.chron.com/advantages-disadvantages-net-present-value-project-selection-54753.html#:~:text=in%20the%20company.-,Disadvantages%20of%20Net%20Present%20Value,that%20have%20differing%20investment%20amounts.
Madison Dern
YesterdayJul 21 at 8:47pm
As we have learned so far, there are many different ways to manage capital. Although this is often an art more than a science, there are luckily some tools outlined by our textbook that are a good starting point when assessing capital management opportunities. They are
1. Payback method.
2. Internal rate of return.
3. Net present value.
Payback method: This a great starting point for analyst to get a basic understanding of the return on an investment. It does this by understanding how long it will take a company to earn back the money that was invested in the first place. It is a very straightforward method and focuses on the liquidity of an asset, which as we know, is something that can make or break a company and is something that investors look closely at. It is a very straightforward method, but the question is if it is too straightforward. This is often a good starting point and basic to consider, but should not be taken at face value for more in depth analysis. I would think that this would be a great tool to use when explaining the investment to individuals who may not be familiar with finance.
Net Present Value: This is the most commonly accepted method when evaluating investments. This method takes into account what the investment is worth on the day where the investment is made and the value of money in the future. This makes it a little more realistic because it gives a more definite number that the investment will need to make. Net Present Value is a more theoretically sound than payback method. Because money is worth more today than it will be in the future, the return from the investment must be able to cover not just the current cost, but future cost.
Internal Rate of Return: Lastly, we have internal rate of return. This is an interesting method because it works very closely with Net Present Value. As our book points out The IRR is the interest rate (i) that makes NPV = 0. This takes into account the financing of the investment and what is needed to see returns. This is a great method, but it definitely has its downsides as well. It is great for the on-paper attributes, but there are many factors other than IRR that should be taken into account. There are projects within a company that might not have a higher IRR, but are necessary for competitive advantage or to make your Employees happy. It does not take int account things like project size or company brand, etc.
Although you have probably not heard of Joywell, a sweet protein manufacturer, you probably have heard of Kraft-Heinz. Kraft recently invested 6.9 million dollars into this company. There is a specific focus on a sugar alternative that is said to be 5,500 times sweeter than sugar, although I cannot wrap my head around that science, I can understand the investment. Industry professionals estimated that sugar alternatives will be worth 16 billion and $20 billion! This is unsurprisingly that Kraft-Heinz is looking to get their hand in this market to help their products stand out.
Block, S. B., Hirt, G. A., & Danielsen, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com (Links to an external site.)
https://www.fooddive.com/news/kraft-heinz-leads-69m-investment-in-sweet-protein-company/581959/
