Peer Responses and Reflection #2

· Select and respond to 3 posts listed below. Advance the conversation; provide a real-world application and experiential examples;

· Conceptually discuss your key [most significant] learning insight or take-away from the selected forum topic comments.

· Responses should be a minimum of 150-250 words , supported by at least one reference outside of the textbook, either supporting or refuting the position of the author of the forum topic response or peer response.

Discussion Topic #1: The Internal Rate of Return

 

   The internal rate of return is a concept that is often addressed when looking into financial management. Osborne, 2011 defined the internal rate of return as the discount rate that sets the NPV back to zero. The concept is primarily used in capital budgeting to compare the profitability of investments.  The higher the internal rate of return that is found then in theory the more profitable an investment the company should be. There are other factors that go into deciding if something is a good investment but the internal rate of return sets a strong indicator.  As the paper further points out there are pros and cons that are associated with using the internal rate of return when deciding financial decisions.

    The internal rate of returns as many positive aspects that go along with it. These strengths are the building blocks of what makes it an attractive option for financial managers. Anthes, 2003 described that is serves as a rate that can be a benchmark for investment decision-making. It is typically the favored method that is used and as a result is fairly universal across most financial managers. Another strength is that it can be applied to many aspects of business and life. For example it can be used to calculate profitable degree offerings for a school all the way down to a business purchase to serve as a point of reference that there will be a strong return. A final strength falls in the usage of the internal rate of return. The IRR is a rate quantity. This is verses options such as the net present value, which indicated the monetary value of a potential investment. The internal rate of return allows a company that is looking into investing to see the efficiency of the company and the quality and yield of the product they are producing. This is a better indicator of the type of investment that a business is about to make. As a final point though the formula can be a bit tricky to understand the overall results are much simpler to interpret than other financial formulas. This makes internal rate of return more user friendly when explaining the findings to committee members that do not have training in financial management, which is often the case when investment decisions are being made.

     Even though there are strengths to using the internal rate of return there are also various weaknesses as referenced by Gitman, 2006. The primary weakness is that internal rate of return should only be used in deciding if a single product is worth the investment. It is less of an indicator rate of projects that have multiple parts. These projects are often referred to in finance as mutually exclusive projects. In these projects there are multiple options that all rely on each other verses independent projects that only have one variable that is under consideration.   In this same vein IRR is not a successful indicators of projects that have different durations. When having projects of different durations it can often skew the numbers resulting in an incorrect IRR. The paper suggests that Modified Internal rate of Return, which has an allowance for cost of capital, might be a better indicator for these types of projects. The complicated nature of the formula is another problem. It is not something that someone with no background in finance can easily use. In the case of a project with positive cash flows that are then followed by negative cash flows the internal rate of return can often have many values. When this happens there must be an additional discount rate calculated. This is often the case when specific items such as machinery are built in order to complete a single project. In this instance where there are multiple IRRs it can become confusing to decide which IRR is best to use, typically though in this case it is the IRR of what is intended to be reinvested back into the project. The biggest factor that must be considered is if the pluses the outweigh the negatives. Even though net present value (NPV) is a more accurate representation when it comes to numbers IRR is still the preferred method due to it including capital budgeting methods in the calculation. Most times these will both come to the same conclusion but it doe have to be kept in mind that there are several exceptions to this case. In cases of non-conventional cash flows where there are positive and negative values and mutually exclusive projects the financial manager must make a determination of if NPV or IRR is going to create a better representation.

Once the limitations of the Internal Rate of Return are understood it is good to understand how exactly the calculation is done. There are many methods with which to calculate it but this is the most straightforward method to do so with. The first step to the process is to calculate the discount factor that will be used. This found by dividing the investment required by the annual cash inflow that is generated.  Once this factor is reached the second step is to find this discount factor on the present value of annuity table. At this point you are ready to use the formula. In the formula NPV= Net present value. The other associated values are n=period and Cn= cash flows and finally r= rate of return.  The formula in the end, ends up looking like this

 

 

As a result of the complexity of the formula it is more common to have the formula entered in an excel spreadsheet. This use of the formula leaves less room for error and is typically the fasted method when multiple internal rates of return need to be calculated.

 

Reference:

 

Anthes, G. H. (2003). Internal rate of return. Computerworld, 37(7), 32. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/216102110?accountid=40195

 

Gitman, L. (2006). Essentials of managerial finance (4th ed.). Boston: Pearson Addison Wesley.

 

Osborne, M. J. (2011). On the meaning of internal rates of return and why an internal rate of return is not an investment criterion. Rochester: Social Science Research Network. doi:http://dx.doi.org/10.2139/ssrn.1634819

Discussion Topic #2: Financial Management of Multinational Firms

This is an interesting topic and one that is often complicated and overlooked.  Take for example a situation some of us may have been in.  In this example we are traveling to a foreign country for a semester abroad.  We are holding our apartment in the United Sates and also require an apartment abroad.  In this process we get an income help from our parents in the US [in US dollars] and also are enrolled in a work study program abroad where we have a foreign currency income. 

This process requires a delicate balance in every aspect of our daily lives.  We need to make sure that we have adequate income in both countries for rent and our expenses.  We may require to convert one currency to the other at times.  There are other issues since we are required to pay income taxes in both countries.  There are also other fees that we need to anticipate such as currency exchanges.  We also need to balance our bank accounts.  We need to have an accurate and up-to-date information about our bank accounts in each country.  We also are required to make financial decisions at times, especially with the fluctuations in currency.  For example, if the Euro is worth more than a Dollar then we need to decide if we need to convert our Euros to Dollars, or vice versa.  At the same time, we need to be aware of the exchange rates.  Also, in The Netherlands for example, the practice of taxation is based on flat rates; also taxing on the saving and investment accounts are far below the US rate.  So we need to be aware of all the benefits each country has to minimize our tax burden.

We now expand this into the business world.  We have a business in The Netherlands with the income and expenses in Euros (EU).  Our parent company is located in the US with the income and expenses in US dollars (USD).  The Dutch branch receives an income of 3,000,000EU.  Do we  invest the income in The Netherlands, do we convert the EU to USD and invest it in the US, and how do we make this transfer of funds.  “Capital Controls” could restrict our ability to convert our income from EU to USD.  Also, if the Dutch branch requires funds for project, how much of the 3,000,000 do we convert to the USD.  To solve this issue, the financial management must use “global cash management” involving “netting”.  That is consolidating the payables and receivables of all subsidiaries and only net differences will be transferred (Srinivasan & Kim, 1986).  Netting requires our firms to maintain an accurate and timely record and reporting of all of our cash flows.

We may require to transfer goods and services besides cash between our branches.  Along the lines of the funds transfer, it is often difficult to take profits out of one country to the other.  To solve this issue firms will often barter for goods to export to their home countries.  The price that our Dutch branch charges the US branch for goods or services is called the “Transfer Price”.  This process will require optimization of a global supply that maximizes the after tax profits of our firms (Vidal & Goetschalckx, 2001).  This process is a rather delicate process; we need to shift profits from the high tax country [The Netherlands] to the lower tax country [United States].  By doing so we can increase the profits of the branch needing to borrow funds at more favorable terms in some cases (Kogut & Kulatilaka, 1994).  The exchange rate between any two currencies is called the “cross rate”, which is calculated based on or relative to the USD.

Capital budgeting is also an important aspect of financial management for our multinational firm.  We need to evaluate the prospective investment alternatives in both countries in order to identify preferred capital expenditures.  To do so our multinational capital budgeting must consider financial risks, political risk, and foreign tax laws (Shapiro, 1987).  As Ryan (2002) found, currently “net present value” (NPV) is the most preferred method/tool versus the “internal rate of return” (IRR) or other tools of capital budgeting. 

Other factors to remember is the inflation, interest rates and exchange rates as a whole when a firm requires to borrow funds.  Lower inflation rates will lead to lower interest rates.  Therefore, borrowing money at a lower rate is more financially sensible to the multinational firms.  For example, the inflation rate is lower in The Netherlands, therefore it is more sensible for our Dutch firm to borrow money there than in the US.  Also we need to be aware that the currency in a low-inflation zone, tends to appreciate more against the currency in the high-inflation zone, therefore the “effective interest cost” increases over the life of the loan (Eichengreen & Hausmann, 1999).

There are many aspects of the financial market and management that are of great importance for firms operating in multiple regions across the globe.  The same concepts of financial management applied to a company in one country applies to their branches or operations in other countries.  The difference arises in the details of the financial management and often meeting requirements by set by each country in which the firm operates.  For example the employee benefits of the european union firm are often more than the ones provided in the US.  With all the differences, many international countries provide an ample workforce with a suitable environment for businesses.  

References:

Eichengreen, B., & Hausmann, R. (1999). Exchange rates and financial fragility (No. w7418). National bureau of economic research.

Kogut, B., & Kulatilaka, N. (1994). Operating flexibility, global manufacturing, and the option value of a multinational network. Management Science, 40(1), 123-139.

Ryan, P. A., & Ryan, G. P. (2002). Capital budgeting practices of the Fortune 1000: how have things changed. Journal of Business and Management, 8(4), 355-364.

Shapiro, A. C. (1978). Capital budgeting for the multinational corporation. Financial Management, 7-16.

Srinivasan, V., & Kim, Y. H. (1986). Payments netting in international cash management: a network optimization approach. Journal of International Business Studies, 1-20.

Vidal, C. J., & Goetschalckx, M. (2001). A global supply chain model with transfer pricing and transportation cost allocation. European Journal of Operational Research, 129(1), 134-158.

Discussion Topic #3: Capital Budgeting and Capital Investment Decisions

Introduction

Every businessman has to take various decisions (short term or long term) in order to run business. To do so, it is very important to analyze future results of the decisions so that effectiveness of the decision can be measured and right decision can be taken. For this, they make use of various tools and techniques. In this paper, we will expand our discussion on a very popular process of analyzing long-term decisions called “Capital Budgeting”.

                                                                                           Meaning of Capital Budgeting

For taking long term decisions, companies often make use of the technique called Capital budgeting. It is an effective process which helps in determining whether to invest in a particular project/investment or not. Capital budgeting, which is also called "investment appraisal," is the planning process used to determine which of an organization's long term investments (Boundless, 2014).  In other words, it is an effective method of allocating funds so that returns can be maximized and risk can be minimized. Under this process, alternatives options are analyzed in terms of profitability, cash inflow and outflow and more to select the best alternative. Generally this process is used to take long term decisions of the business such as purchase of an asset, investment in project, acquisitions and more. This method is known as “Capital Investment Decisions”.

The process of capital budgeting can be divided into six steps; they are Identifying project, defining and screening of project, evaluating, implementing, monitoring and post audit.

Techniques of Capital Budgeting

Capital budgeting offers various techniques such as net present value, payback period, discounted payback period, internal rate of return, modified internal rate of return and more. Selection of technique depends upon number of factors such as objective, amount of investment, choice of person, outlook of management and more. Some of the important techniques are described as under:

· Payback period: With the help of this method, one can estimate the period in which initial cash flow can be recovered. It is a very simple method and does not involve discounting of cash flows. Generally, the investment whose payback period is lowest or less than the target payback period is considered by the businessman. It means lower the payback, faster will be the recovery of cash. In case of even cash flow, payback period can be calculated as :

                        Payback Period = Initial Investment/ Cash inflow per period

For instance, a company wants to invest $10,000 and it is expected that this amount will provide cash flow of $2000 every year. In this case, the payback period will be 5 years ($10000/2000).

Due to its various drawbacks like non-use of discounting, time value of money, opportunity cost etc. this method is not preferred by the businessman.

· Net Present Value: It is a very popular and widely used technique of capital budgeting.  Net present value is a calculation that compares the amount invested today to the present value of the future cash receipts from the investment (Avercamp, n. d.). This method considers time value of money and cash flows are discounted on some specific rates in order to know the present value

            Decision Rule: While analyzing two or more projects, the project with highest NPV is accepted. In other cases, the project can be accepted when NPV is positive or zero. For instance, if a company wants to spend $20,000 and present value of future cash inflows after discounting is $22,000. In this case, the decision can be accepted as NPV is positive.

· Internal Rate of Return (IRR): It is also known as time-adjusted rate of return method. In this method, time value of money is taken into consideration. In order to understand this method, it is essential to know the meaning of internal rate of return. Internal rate of returns refers to the rate of return which an investment promises to generate. While using this method, management decides some minimum rate of return and compare it with IRR to take decision. It can be calculated as:

PV of future cash flows − Initial Investment = 0

At IRR, Net present value is always zero.

Decision Rule: In case, if IRR is equal or greater than rate determined by the management, the project will be accepted.

            Under this method, it is difficult to convey annual profitability of the investment. In order to overcome this shortcomings, a new method is evolved which is called “Modified Rate of Return” (MIRR).

· Profitability Index (PI): “The Profitability Index (PI) is determined by dividing the current value of cash inflow by the original cost, thus it evaluates essential productivity which is the amount of current value per dollar of investment” (Ehrhardt & Brigham, 2011). With the use of this method, one can rank the projects and make his decision in appropriate way.

· Equivalent Annuity Method: The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor (Boundless, 2014).

In this competitive business world, there is no place for trial and errors. Thus, the importance of capital budgeting is continuously increasing. Today this method can be used by every kind of businessman irrespective of size, nature and type of business.

 

Importance of Capital Budgeting

There might be many different criteria’s for choosing the appropriate and right capital investment decision. For e.g., a company might stress on projects that assure for prompt returns while a few other companies might assert on projects which ensure for a growth in the long term (Venture Giant, n. d.). Capital budgeting plays a vital role in business. This concept not only helps managers to take capital investment decisions but also reduces the risk of uncertainty. Capital Investment decisions generally require lots of time and money and risky in nature. Further these decisions are irreversible in nature and can hinder the existence of the organization as well. Thus, it is very essential for the managers to make appropriate selection of technique in order to evaluate the project and select the best one.

 

 

References:

Averkamp, H. (n. d. ). What is NPV? Accounting Coach. Retrieved from

http://www.accountingcoach.com/blog/npv-net-present-value

 

Boundless (2015, January 6).  “What is Capital Budgeting?” Boundless Finance. Jan. 2015.

Retrieved from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/capital-budgeting-11/introduction-to-capital-budgeting-91/what-is-capital-budgeting-390-8292/

 

Ehrhardt, M. C., & Brigham, E. F. (2011). Corporate Finance (4th ed.). Mason, OH: Cengage Learning.

 

Ventura Giant (n. d.). Capital investment decisions. Retrieved from

            http://www.capital-investment.co.uk/capital-investment-decisions.php

 

 

Discussion Topic #4: Net Present Value

            In finance the net present value is a present value of a specific project's cash flow and outlay i.e. sum of the present values of incoming and outgoing cash flows in a specific period of time for a specific investment. Therefore after evaluating investment critically based on time value money we can measures the most net desirable increase and undesirable decrease in firm's wealth for a particular project in question. The net present value is "calculating the difference between the sum of the present values of the project's future cash flows and the initial cost of the project" (Ross, 2010).

             The NPV formula is very useful in determining whether investing in particular project will get benefit or suffer in loss. If calculated value from the NPV formula is positive that means investment is profitable and if the result is negative we should not take any risk because there are very high chances of losing money in that investment. The purpose of investing is to make money not losing it and NPV guides and serves the purpose of measuring the excess or shortage of cash flow based on present value. Timing of investment is very important factor because the value of today's cash flow is higher compare to identical cash flow in near future because of variable discount rate and the expected rate of return. Therefore the company should pursue all investments with positive NPV and whose cost cash flows does not exceed the company's capital.

            Therefore when future cash flow are incoming and only outflow of cash is purchase price, the net present value is present value of the future cash flows minus the purchase price. It also can be defined as difference amount between the sums of discounted cash inflows and cash outflows. Actually it is a comparison between present value present value of the money today and present value of money in the future taking inflation and returns in account.

            It can be explained further as a process of determining what cash to be received in future is worth in term of today's dollar value. This process is called discounting or the interest rate used to calculate present value is called discount rate. To take an example, consider present value $1,000 to be received one year from now is $900.91 if the compounded discount rate is 10%.

In one year $1,000 = $909.091 (1 + 0.10)  or

                   $909.09 = $1,000 / (1 + 0.10)     

In two year $1,000 = $826.45 (1 + 0.10)² or

                   $826.45 = $1000 / (1 + 0.10)

PV = CFᵗ / (1+r)ᵗ

PV = Present Value

CFᵗ = Future cash flow at t years from now.

r =the interest rate or discount rate.

t = the number of years.

            The concept of present value is very useful for lottery winner in determining it's real worth.  For an example say the net present value of state lottery prize is $1 million but it's actual value is $468,246 when promised to pay $50,000 per year for 20 years at 10% discount rate.

            The NPV guides the management in a way that it should undertake only those project which have positive NPV because it increases wealth and where as negative NPV projects decreases the wealth. But the NPV technique is very tricky because it is fully dependent on appropriate value of discount rate that may lead to lose firm's wealth rather than increase it. Allen said that most important task of financial management is asses their net present value by critically evaluating risk of undertaken projects, projected cash flow, and discounting of projected cash flow.

            Actually NPV is directly related to particular project's cash flow and the cost of capital. The cost of debt should be less than rate of return in order to approve loan for new internal or external projects. But when we consider to invest in customer orientation companies the NPV can not quantify same as investment in manufacturing companies because of its intangible benefits.

            Present value also helps us to determine whether to build an international airport on undeveloped land for away from the main city or not, because 20 year from now city will have expanded to reach the airport. That means that for twenty years, people will spend valuable time going the long distance to and from the airport. The gain is that twenty years from now the airport will be appropriately situated. But because the gain from appropriately locating the airport is so far in the future, the present value of this gain is small; therefore, building the airport so far away today probably does not make sense.

            Therefore the net present value (NPV) or net present worth (NPW) is a method for evaluating the profitability of an investment or project. The net present value of an investment is the present (discounted) value of investments in the future, also determined as the present value of an investment's future net cash flows minus the initial investment. The present value analysis is a useful concept in decision making by taking into account the role of time in this process. The tie of cash flows is relevant for the decision-maker because in a period of time, the master rate, the inflation can generate gains or loss. Anthes recalls of Ian Campbell saying that NPV has some flaws by citing an example that two investment have same NPV but one with the higher initial investment is safer than the other.

 

            By recognizing the time value of money and equating dollars from different years, net present value makes it possible to evaluate long-term investments. NPV is a central tool in discounted cash flow analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, because it measures the excess or shortfall of cash flows, in present value terms.

 

  

 

References

Allen, D. (1996). Net present value revisited. Management Accounting, 74(5), 56. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/195658891?accountid=40195

Anthes, G. H. (2003). Internal rate of return. Computerworld, 37(7), 32. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/216102110?accountid=40195

 Ross, A. S., Westerfield, W. R., & Jaffe, J. (2010). Corporate Finance (9th ed.). New York, NY: McGraw-Hill Irwin

Discussion Topic #5: Net Present Value - It’s relevance for investment decision-making

There Net Present Value (NPV) is a term in finance that basically defines the net present worth of a company or particular project a company has either put into place, or is considering putting into place and the total sum of the present value of cash flow related to it. It is a calculation that is used as a decision criteria for evaluating investment or financing opportunities. It allows analysts to determine the worth of future projects and the value it would bring to the company - adjusted in terms of present day dollars (Steinberg, 1997). Simply put, the NPV provides the future income from a project, expansion, or acquisition in terms of today’s money. This can be done with multiple projects or potential expansion and acquisition ideas, then the cash flows for each may be summed up and compared (Steinberg, 1997). The NPV can also can be utilized to reveal the value of various current projects, and segments of a company. 

When utilizing the NPV, there are certain basic rules that are obvious from the beginning to financial analysts. This is that any projects or endeavors that show a negative NPV should be thrown out and those with a positive NPV considered. Those projects with a positive NPV should not inhibit the undertaking of other projects (Ross, 1995). The general benefit of using the NPV method of analysis is by taking into account the “time value of money”, it allows consideration of other important financial commitments such as cost of capital, interest rates and investment opportunity costs (Anthes, 2003). This is a particularly valuable tool for evaluating long-term projects. Where it lacks benefit is when ranking opportunities by NPV, it doesn’t allow for complete comparison of levels of investment. 

The NPV takes into account the cash flows. It does not look at profits and losses and it is not effective at factoring discount percentages. It looks at the “time value of money” by suggesting future cash flows based upon their current value (Anthes, 2003). It recognizes that there is interest to consider, so that you would rather have one dollar today, then one dollar a year from now. If an investment offered ten percent interest, then a year from now the dollar would be worth ten cents more. Therefore, this would be a positive investment and a positive NPV. The larger the NPV amount, the better the investment. Alternatively, if an investment was showing a present value of a dollar today as $1.10 and in a year it was worth $1.00, then this would not be a favorable investment. It would likely show a negative NPV. Typically, in calculating the NPV, analysts would use a discount rate that at least meets a desired minimum rate of return for determining what is a positive and what is a negative investment (Anthes, 2003). This could be set at the “cost of capital” (Anthes, 2003). If it costs the company ten percent on the capital, then the company would expect to get a return from the investment somewhere close to that. Therefore, if you determine your discount rate at ten percent, you would apply a discount factor of .90 that is applies to future year’s cash flow to convert it to today’s dollar value. The equation used: 

Discount factor = 1/(1+i)sup n   where i = target rate of return and n = # of years  (Anthes, 2003)

For example, if Year 1 the target rate of return is 10% (.10), then:

discount factor = 1/(1 + .10) 1 = .909   (Anthes, 2003)

If the present value were $1.10, then a year from now the $1.10 x .909 = $1.00 (Anthes, 2003). 

The NPV figured by the minimum expected return (taking into consideration calculated interest rate) reveals the amount of “wealth growth” that has accumulated by the investment throughout it’s duration; without including the profitability of the capital investment (Juhasz, 2011). In order to make more comprehensive financial decisions on new projects, the analyst must also include the Internal Rate of Return (IRR). 

This is similar to the NPV, but represents additional information not represented solely by the NPV. The IRR calculates a return rate that breaks even; with a discount rate that produces a yield right below a positive NPV and right above a negative NPV - showing cash outflow equal to cash inflow (Anthes, 2003). It is the discount rate that results in an NPV of zero for various calculated future cash flows (Anthes, 2003). This information is valuable to show if a project is less than your cost of capital required to undertake the project, or at least yields the minimum desired rate of return. 

Therefore, using the NPV alone for determining the value and return for future and current projects or investments is not highly advisable in recent literature. Most analysts and financial advisors suggest using a combination of decision-making tools. Namely the NPV and IRR together - as well as some modified versions of these tools. The IRR in conjunction with the NPV, which shows asset growth for the duration of the project as well as the IRR value showing profitability on capital, proper investment-profitability decisions for future projects or investments can be made (Juhasz, 2011). These two together ensure more accurate decisions. 

References:

Anthes, G. H. (2003). Net present value. Computerworld, 37(7), 30. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/216081918?accountid=40195

Anthes, G. H. (2003). Internal rate of return. Computerworld, 37(7), 32. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/216102110?accountid=40195

Juhász, L. (2011). NET PRESENT VALUE VERSUS INTERNAL RATE OF RETURN. Economics & Sociology, 4(1), 46-53,126. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/1038451731?accountid=40195

Ross, S. A. (1995). Uses, abuses, and alternatives to the net-present-value rule. Financial Management, 96-102.

Steinberg, S. M. (1997). What is the net present value of your agency to the principal? Agency Sales, 27(2), 28-31. Retrieved from http://search.proquest.com.proxy.davenport.edu/docview/210945000?accountid=40195

 

 

Discussion Topic #6: NPV and Capital Budgeting Investment Rules

 

            Financial management requires that managers be able to make good decisions when it comes to the investment of money.   The tools they use to achieve this are called capital budgeting.  Capital Budgeting is the process of analyzing and selecting projects (Capital Budgetin, n.d.) that the company will invest in to generate a higher value for the firm.   Making correct capital budgeting decisions is imperative for the success of the business. 

            To begin with, companies first need to identify opportunities that are available to them (The importance of, n.d.).  Long term growth of an organization requires that companies are continuously looking for ways to increase the value of the organization.  Missed opportunities can result in poor performance of a company.  Opportunities can be purchasing new equipment, expanding locations, or adding new product lines.

            Second, companies need to look at each of the opportunities available and determine which is the most valuable to the organization (The importance of, n.d.).  In order to make these decisions, companies need to determine the benefits of the investment. There are three primary ways to determine these benefits:  the net present value method, the payback method, and the internal rate of return method (Marzec, n.d.).

Net Present Value Method

            The net present value rule uses discounted cash flows that evaluate the current value of an investment by looking at the risk and time value of the investment (Peavler, n.d.).  By converting future cash flow back into present day money using the discount rate, it is possible to determine the actual value of the future cash flows.  The net present value is the most accurate way to determine if a project is expected to be beneficial, but is tedious to calculate. 

            Calculation of the net present value requires the amount of the initial investment, the discount rate (the available market interest rate), and the expected future cash flows.  .  If the sum of the future cash flows is more that the initial investment, the project should be accepted.  These calculations are difficult to do by hand, however spreadsheets can easily accomplish the task.

Payback Method

            The payback method of capital budgeting techniques is one used by many firms, especially small businesses (Peavler, n.d.).  The calculation of the payback method is quite simple; subtract the future cash inflow from the initial investment in order to determine how long it will take to recoup the investment. 

            The advantage of using the payback method is ease.  Because these calculations can be made quickly and easily, companies can determine which investment will provide the fastest return of the investment, which is important for cash strapped companies (Woodruff, n.d.).  Additionally, the ease at which these calculations can be solved requires little explanation to employees. 

            The disadvantage of the payback method is that it does not look at the time value of money or the long term cash flows (Marzec, n.d.).  This could result in projects being rejected that my actually provide long term profits to the company.  Many capital investments will provide cash inflow far into the future and well after the initial investment is recouped.  Therefore, managers use the payback method as an initial tool in order to determine if a project should be considered (Woodruff, n.d.). 

            Because the time value of money is important to companies, some managers use a discounted payback method (Ross, Westerfield. Jaffe, 2013).  This is accomplished by finding the present value of the future cash flows and using them to determine how long it takes to recoup the investment.  However, doing this is the same as calculating the present value of the investment, and simply subtracting the initial amount calculates the net present value. 

Internal Rate of Return Method

            The internal rate of return is the rate of return on the investment that results in the net present value being zero (Marzec, n.d.).  The formula for calculating the internal rate of return is complicated but can be determined easily with a spread sheet.   Using this rate companies can determine the profitability of the investments.

            When trying to decide between several different investments, the internal rate of return is extremely valuable.  First, the internal rate of return must be more than the cost of the capital used (Wright, n.d.).  It would not make sense for a company to use debt or equity financing in order to invest in a project that has a return less than the cost.  Second, the internal rate of return is valuable because it can be used to determine the best investment (Wright, n.d.), because the project with the highest internal rate will generate the most profits. 

Choosing the Method

            Every business has their own way of making decisions when it comes to capital budgeting.  In order to make the best possible decision, companies need to look at the l profitability of investments before making any decisions.  For quick, low cost decisions, the payback method works extremely well.  Managers can quickly determine how long it will take to recoup their investment.  However, with investments that require large up front capital, the payback method is not very useful because the investment will most likely a long term investment.

            For larger capital investments, the net present value method is very useful.  By discounting future cash flows into preset values, managers can see whether the investment will be profitable.  If the net present value is positive, the investment is profitable in the long term, and therefore it should be considered. 

            When trying to decide between two or more capital investments, the internal rate of return is the most useful.  Managers are often faced with choices between several opportunities, and applying the internal rate of return to each of them determines which is the most profitable.  Additionally, using the internal rate of return allow for easy comparison to the cost of capital. 

Conclusion

            Before the “computer age” the payback method was a quick way for managers to determine how long it would take to recoup the investment, and without advanced mathematical skills it was very useful.  However, since computers are almost a requirement for any business, the net present value and internal rate of return are very easily calculated.  Most businesses use several of these methods when making decisions (Marzec, n.d.).   Using all the methods available will result in the best decision making.  The payback method is great if a company is looking for a quick return, but for long term benefits the net present value and internal rate of return are most appropriate.   

References

CAPITAL BUDGETING PROCESS; MEANING AND PROCESS. (n.d.). Retrieved January 13, 2015,      from http://www.accountantnextdoor.com/capital-budgeting-process-meaning-and-    process/

Wright, T. (n.d.). Why Is the Internal Rate of Return Important to an Organization? Retrieved      January 13, 2015, from http://smallbusiness.chron.com/internal-rate-return-important-        organization-67279.html

Marzec, E. (n.d.). Three Primary Methods Used to Make Capital Budgeting Decisions. Retrieved             January 13, 2015, from http://smallbusiness.chron.com/three-primary-methods-used-            make-capital-budgeting-decisions-11570.html

Peavler, R. (n.d.). Net Present Value as a Capital Budgeting Method - NPV. Retrieved January 13,           2015, from http://bizfinance.about.com/od/Capital-Budgeting/a/net-present-value-npv-         as-a-capital-budgeting-method.htm

Ross, S., Westerfield, R., & Jaffe, J. (2013). Corporate finance (10th ed.). New York: McGraw-       Hill/Irwin.

The Importance of Capital Budgeting. (n.d.). Retrieved January 13, 2015, from             http://www.finweb.com/financial-planning/the-importance-of-capital-      budgeting.html#axzz3OkHBpZW0

Woodruff, J. (n.d.). Advantages & Disadvantages of Payback Capital Budgeting Method.   Retrieved January 13, 2015, from http://smallbusiness.chron.com/advantages-     disadvantages-payback-capital-budgeting-method-14206.html

Discussion Topic #7

  There were several great topics to choose from and this weeks for a response, however I felt that the most critical in my opinion is the future value of money and compound interest. I feel that as a young investor especially, having a full grasp of this type of concept will allow an individual to not only view their investment from the narrow scope such as in the current state of time, rather it will allow them to dig a little bit deeper, and realize the true potential that they may be tapping into. Sometimes, especially for a younger individual they may get caught up in wanting to see quick games on an investment by worrying about how much money they will make off of it in the near future. There is nothing wrong with this approach, however the goal of investment should not be to simply make a quick buck during the short term in my opinion, the goal of successful financial management should delve much deeper than that, and should include making wise decisions with your money so that you can accrue revenue for years to come. If one has the concept down in this regard, it is simpler in my opinion to gain this money over the long term because of the benefits of compounding interest and how this rollover affect will play into the future generation of revenue.

 

          Simply put, the value of a dollar in years to come after being placed in the right manner today should not be taken lightly. By making the wise choice to invest money rather than spend it on material goods, you allow your money to go to work for you, which will ultimately provide you with a substantial amount of additional income as you enter the twilight of your professional life. Compound Interest in and of itself can be key to making substantial income, however acting now rather than later is the way to achieve this. (Dykman, 2011) Now that I have tried to place a substantial amount of emphasis on the importance of this concept, it is time to get into the nuts and bolts.

 

          Starting with a simple definition, the future value basically refers to the opinion that money that is in hand at the present time is actually worth less than the same amount of money in the future because of the concept of potential earning capacity. If you take the time to factor in this potential, if invested wisely that same amount of money can be worth far more in the future. Now that we understand what the time value of money and compounding is, we must now familiarize ourselves with the formulas that are necessary to calculate these figures. 

Pn = P0(1+r)n 

         

          The above equation can be used to help us predict how much money invested now will be worth within a given number of years. For the equation, Pn is the future value, Po represents the current investment that you are making, r represents the rate of interest that you will receive on this investment, and n represents The number of compounding periods that will take place, for example years if the investment is compounded yearly. So now to better show this example, we can plug in some numbers. Say for example I decide to invest $20,000 into a fund that will gain and interest rate of 9%. Now say for example I want to know before making the investment, how much that money will be in 20 years time. I would simply plug these numbers into the above equation, and after making the proper calculations I will find that in 20 years, this $20,000 will actually be worth $112,088.22. The first time I ever used this equation to plug in numbers, needless to say I was mind blown by the amount of money that can be earned with a simple investment at a fixed, compounding interest rate.

 

          While this seems like a relatively easy concept to understand, it is important to know that there are several factors that must be considered while viewing this figure. There are several advantages and disadvantages that come with making a future value investment. Simply by using the equation above, one can see the benefit of compounding interest and how you can make it assist you and dramatically increasing the value of your investment. Aside from this, I feel that probably be most beneficial part about making this type of investment is the security that comes with it. Although it is a long-term investment, it is a highly secure one, usually made through a bank which is federally funded. This means that many factors that very when it comes to making an investment are not applicable to a future value investment, such as chance changes that may take place. This is in stark contrast to an article that I recently read about Russian billionaire Mikhail Prokorov, the owner of the Brooklyn Nets NBA franchise. Prokorov made a large amount of his current value through investing in oil, and with the recent changes that were seemingly unexpected he may now have to sell the team. (Davidson, 2015) As for the disadvantages, one of the main drawbacks has to be the amount of patience one has to have in order to actually see these gains. Another substantial risk that this investment is subjected to because it takes place over the long term is inflation. Over time, as the cost of things dramatically increase, something that may have cost that same $20,000 20 years ago may now cost around $30-$40,000. After taking this into consideration, the $112,000 made off that one investment does not seem quite as sweet. With that said, many times the compounding interest will outweigh the cost of inflation, which is why these types of investments are so heavily relied upon for their trustworthy nature and consistent returns. This type of foundation has been used not only by American investors, but by some of the top international investors in the world such as Francisco Garcia Parames of Spain, who was able to achieve an average of 16% of annual returns over the past 2 decades. (Hale, 2015)

 

          All in all, I feel that the benefits far outweigh the risks in terms of making a future value investment. In fact, this is one of the things that I struggle with currently because I am a medical student. The education causes me to delay earning power in order to pursue the education necessary to get a job as a physician costs me in the sense that I lose many years of compounding interest in between my 20s and 30s. Because of this, I feel that it is extra important for me to gain a grasp on all of these financial concepts, so that when I do gain the ability to have my own earning power, I can make wise financial investments that will allow me to accrue money over the course of my career.

  

Davidson, Kavitha. 2015. You’d Sell The Nets, Too. http://www.bloombergview.com/articles/2015-01-13/youd-sell-the-nets-too

 

Dykman, April. 2011. How Savings Accounts Grow From The Magic of Compound Interest. http://www.forbes.com/sites/moneybuilder/2011/12/12/how-savings-accounts-grow-from-the-magic-of-compound-interest/

 

Hale, Thomas. 2015. Top Spanish Fund Manager Francisco Garcia Parames To Go It Alone. http://www.ft.com/cms/s/0/30e5e744-974a-11e4-9636-00144feabdc0.html#axzz3OkenOauf