ATC 10-4 Writing Assignment Limitations of capital investment techniques Webb Pu
ID: 2796973 • Letter: A
Question
ATC 10-4 Writing Assignment Limitations of capital investment techniques Webb Publishing Company is evaluating two investment opportunities. One is to purchase an Internet company with the capacity to open new marketing channels through which Webb can sell its books. This opportunity offers a high potential for growth but involves significant risk. Indeed, losses are projected for the first three years of operation. The second opportunity is to purchase a printing company that would enable Webb to better control costs by printing its own books. The potential savings are clearly predictable but would make a significant change in the company's long-term profitability. Required Write a response discussing the usefulness of capital investment techniques (net present value, inter- nal rate of return, payback, and unadjusted rate of return) in making a choice between these two alter- native investment opportunities. Your response should discuss the strengths and weaknesses of capital budgeting techniques in general. Furthermore, it should include a comparison between techniques based on the time value of money versus those that are not.Explanation / Answer
Usefulness of Capital Investment Techniques
1. Capital investment techniques are most important tool in financial management.
2. It provides immense scope to evaluate different projects in terms of their viability.
3. It is useful in understanding the risk and uncertainty of different projects before investing in them.
4. It gives information about, if any, over or under investments.
5. The cost of capital expenditure projects can be effectively controlled by the management.
6. It helps the business to optimally use availabe resources.
Advantages/Strengths and Disadvantages/Weaknesses of Capital Budgeting techniques
1) Pay-back Period
Advantages -
1. It is easy to caluculate and understand as well as it gives overall view as to how long (time period) it will take to get money invested in different projects.
2. It helps to know within how many years the cashflow will become positive and useful of a project.
3. If money is recouped in less time period then the risk associated will also be less, so less uncertainty or risk.
Disadvantages
1. Cashflows raised after pay-back period are ignored.
2. The pattern of cashflows over a period of time is considered to be uniformed which means magnitude and timing of cash inflows are ignored.
3. It is not useful method to measur the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.
4. Administrative difficulties may be faced in calculating the maximum acceptable payback period.
2) Accounting Rate of Return method (ARR)
Advantages -
1. It is very simple to understand and use.
2. It can be easily calculated using the accounting data.
3. It considers the total of incomes/profits throughout the life of project in calculating the accounting rate.
Disadvantages -
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. Timing of profits are not considered as the average is used.
5. The calculation of profits depends on different accounting policies.
6. There is no specific method for calculating ARR.
7. It does not allow for the fact that the profit can be reinvested.
3) Net present value method (NPV)
Advantages -
1. It considers the time value of money
2. It considers all cash flows over the entire life of the project while calculating NPV.
3. It is consistent with the objective of maximizing the welfare of the owners.
Disadvantages -
1. It is difficult to use
2. It assumes that the discount rate which is usually the firm’s cost of capital is known. But in practice, it is quite difficult concept to understand cost of capital.
3. It may not give satisfactory results when the projects being compared involve different amounts of investment.
4) Internal Rate of Return Method (IRR)
Advantages -
1. Like the NPV method, it considers the time value of money.
2. It considers cash flows over the entire life of the project.
3. It satisfies the users in terms of the rate of return on capital.
4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.
5. It is compatible with the firm’s maximising owners’ welfare.
Disadvantages -
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances.
3. It implies that the intermediate cash inflows generated by the project are reinvested at the internal rate unlike at the firm’s cost of capital under NPV method. The latter assumption seems to be more appropriate.
Comparison between techniques based on time value of money and techniques not based on time value of money
No. Techniques based on time value of money Techniques not based on time value of money 1. Calculation in terms of money/currency in NPV method. Calculation in terms of period of time to repay total initial investment in pay-back method. 2. The methods accounts for time value of money, inflation, risk. The methods don't account for time value of money, inflation, risk. 3. The total value of project is considered. The total value of project is not considered. 4. The IRR is the discount rate at which the NPV for a project equals zero.(the present value of the cash inflows equals the present value of its outflows)The IRR is the break-even discount rate found by trial and error. The ARR method (also called the return on capital employed (ROCE) or the return on investment (ROI) method) of appraising a capital project.Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.