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Feasibility Study Essay

2041 words - 9 pages

C 15/1: Economic Feasibility Studies Capital Budgeting Techniques Pathways to Higher Education 19 Chapter 2: Capital Budgeting Techniques Introduction The Net Present 2.2 The Net Present Value Method Value Method Estimating NPV 2.1 Introduction In order to assess the feasibility of any investment project, some capital budgeting techniques should be used to evaluate that project. This part illustrates the most common techniques and the advantages and disadvantages of each one of them. The primary capital budgeting method that uses discounted cash flow techniques is called the Net Present Value (NPV). Under the NPV net cash flows are discounted to their present value and then compared with the ...view middle of the document...

2.3 The Payback Period Rule The payback period answers the question of; how long does it take the project to "pay back" its initial investment? Payback Period = number of years to recover initial costs The shorter the payback period the more attractive the investment. The reasons are that: The earlier the investment is recovered, the sooner the cash funds can be used for other purpose. The risk of loss from obsolesces and changed economic conditions is less in a shorter payback-period Minimum Acceptance Criteria: set by management Ranking Criteria: set by management Disadvantages: Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria An accepted project based on the payback criteria may not have a positive NPV Advantages: Easy to understand Biased toward liquidity 2.4 The Discounted Payback Period Rule How long does it take the project to "pay back" its initial investment taking the time value of money into account? However, by the time you have discounted the cash flows, you might as well calculate the NPV.C 15/1: Economic Feasibility Studies Capital Budgeting Techniques Pathways to Higher Education 21 The Average Accounting Return Rule The Internal Rate 2.6 The Internal Rate of Return (IRR) Rule of Return Minimum Acceptance Criteria Ranking Criteria 2.5 The Average Accounting Return Rule Another attractive but fatally flawed approach. Ranking Criteria and Minimum Acceptance Criteria set by management Disadvantages: Ignores the time value of money Uses an arbitrary benchmark cutoff rate Based on book values, not cash flows and market values Advantages: Accounting information is usually available Easy to calculate IRR is the discount rate that sets NPV to zero. The IRR differs from the NPV in that it results in finding the internal yield of the potential investment. The IRR is calculated by discounting the net cash flows using different discount rates till it gives a net present value of zero (Trial and Error). However, it may be easily calculated using financial calculators or Excel Program. 2.6.1 Minimum Acceptance Criteria Accept if the IRR exceeds the required return. Ranking Criteria Select alternative with the highest IRR. Reinvestment assumption: All future cash flows assumed reinvested at the IRR. Disadvantages Does not distinguish between investing and borrowing? IRR may not exist or there may be multiple IRR Problems with mutually exclusive investments Advantages Easy to understand and communicate AAR = of Investent Value Book Average Net Income AverageC 15/1: Economic Feasibility Studies Capital Budgeting Techniques Pathways to Higher Education 22 The Profitability Index Mutually Exclusive Independent Projects The Practice of Capital Budgeting 2.8 The Practice of Capital Budgeting Selection of Techniques 2.7 The Profitability Index (PI) Rule Initial Investment = Total PV of Future Cash Flows PI Minimum Acceptance Criteria: Accept if PI...

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