Budgeting Approval And Authorization Stage Finance Essay

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Capital budgeting and investment appraisal are one of the means of generating revenue for projects and as well using techniques to evaluate the way the project should be financed in other to ensure efficient maximization of resources. According to (fabozzi, 2009) it was highlighted that company's main reliability for long term funds are usually invested in the assets of the company. The generation from capital from these assets are then used to fund projects. (BPP, 2009) Described capital budgeting as a series of processes that require the identification, analysing and selecting the best result that will yield a profitable return. According to (fabozzi, 2009) described five stages of choosing a project and these stages are:

The investment screening and selection stage

Capital budgeting proposal stage

Budgeting approval and authorization stage

Project tracking

Post completed audit

Each stage plays a vital role in the choosing of the projects. According to (Dayanda, 2002) in their book they said the objective of capital budgeting is to maximize shareholders wealth, and then three types of decisions would be taken which are:

Financial decision

Dividend decision

Investment decision which is subdivided into two long term and short term investments

The long term investment decisions are the ones that lead to Capital budgeting and through capital budgeting projects are being derived now, projects are to be used in organisations there are several projects to be used for a particular decision, this is where capital investment appraisal comes into play, there are several methods that are used to evaluate the most efficient methods to be used in a project and this methods would be spoken about further mire as this academic writing proceeds

Methods of investment Appraisal

(Atrill, 2002) identified the four investment appraisal methods that are used in the evaluation of projects and these methods are:

Accounting rate of Return (ARR)

Payback Period (PP)

Net present Value (NPV)

Internal Rate of Return (IRR)

Application and Evaluation Of capital Budgeting and investment techniques to the Case of Alpha PHC

(BPP, 2011) Describes that the generation of cash flows for a project must be relevant, they arrived as a result of the decision made:

We are dealing with only cash flows in the investment analysis so depreciation is ignored

Any cost that have been incurred or that have been committed to the cash flow must be included in its base

Ignore cost that are centrally allocated for example Overheads cause they will be incurred regardless of whether the project is undertaken or not.

Always include the opportunity cost that lead to the cash flow.

So based on this theory lets determine the cash flow for the relevant years

ALPHA PLC

Year

Cash flow

1

(174000)

2

216000

3

258000

4

300000

We have gotten the cash flow of each relevant year, so now we can embark on the use of investment appraisal methods in the evaluation and analysis of our work as well as relate our figures with relevant theories.

NET PRESENT VALUE (NPV)

According to Andrew T. Adams (2003) suggest that the NPV is an investment appraisal technique that measures the added value of undertaken a project by a company Bierman and schidt (1966) describes NPV as the summation of all present value (which is determined by the use of cost of capital and relevant cash flow) of an investment. It measures the probability of generating profit through project selection from the beginning of the project to the point at which the project might be chosen it entails the use of interest rate as well as cost of capital and also relevant cash flows in its computation. So by this brief definition we will now determine what the NPV of Alpha limited is and then analyse the result.

NPV for ALPHA Limited = +76140

From the calculations of our NPV which is shown on the appendix after this work. We derived a positive NPV of 76140. NPV method of appraisal suggest that if a company analysis its project and it produces a positive NPV the project it should be accepted cause that means it will be a profitable investment , and its viable.

The use of NPV is widely used by organisations but it as its fault as well as advantage it has its advantages of not ignoring the time value of money as shown when we were calculating the cash flows of the organisation we used the years as part of our discounted cash flow method , but one of its disadvantages, according to Brendon Mc Sweeney (2006) is how realistic and true is the forecasting cash flow from the determination of the cash flow above we relied on estimation rather than facts, some organisations might give in appropriate cash flow and this might mislead to a positive NPV while in actual fact with the right information it might give a negative NPV, so how accurate is the data given. Then also an advantage is the use of cost of capital in evaluation, I the question our cost of capital was 15% and another disadvantage is the accurate determination of the cost of capital if, the figures are wrong just like the cost of equity and debt how effective will the cost of capital be. It cannot be really predicted how to determine the cost of capital to be used for NPV analysis. Then through the use of NPV the risk associated with a project will be minimal if the realistic information and right cost of capital are used.

INTERNAL RATE OF RETURN (IRR)

BPP (2006) The IRR assumes that the NPV will be NIL, if the IRR is above the rate of return the project should be undertaken. The IRR and the NPV are the new accounting techniques as portrayed to the old or traditional means of appraisal. Below is the solution to the problem of Alpha PLC using the IRR method of appraisal?

From the calculation we assumed a higher DCF factors as 40% and this gave us a -165,060 so therefore according to the formula the IRR = 15.8%

From the above illustration the IRR method of appraisal suggest that if the IRR is greater than the cost of capital you accept it since the cost of capital is 15% and the IRR is 15.8% accept the project.

The IRR and NPV has similar if not the same advantages since the both make use of the time value of money as well as cost of capital which is 15% in this question. One of the disadvantages of this method based on my calculations is that it deals with assumption towards the estimation or deprival of the negative NPV that would be used in the computation of the IRR the 40% was on bare assumptions, then also the cost of capital to effectively can you calculate the cost of capital required for a particular project. This is another area that makes NPV and IRR uncertain to certain scholars and most of this application of NPV and IRR are based on perfect condition under MR Fisher's theory of perfect market analysis as seen no form of demand competition or several factors are included in its calculation. So the data also presented is it reliable to give appropriate information so there are so many limitations as well, but these two new techniques are used frequently by modern era business since they put into consideration the basic important things cash flow, cost of capital and most importantly time value of money. So it can accommodate any form of inflation and economic crises.

Payback period (PP)

Bandari (2009) discussed that while NPV methods are used in the assurance of the profit base in an organisation it does not ensure the liquid form of an organisation. He thereby continued that the Payback period on the other hand ensures the organisation is in a suitable liquid form as pertaining to profit. Most organisations are more concerned with the profitability and they lay less emphasis that's why PP is not widely observed and its tradition. Basically payback period is simply just the way the expenses of the organisation can be covered by the returns on the investment within a period of time. The payback period is more traditional and its not effective in the modern era. Below is the payback period of the project which is approximately 3years 2months.

This project should be chosen because it shows that the company will have a strong liquidity form and would be able to generate profit and will as well a going concern. The payback period has its own advantages as well as its disadvantages. And advantage of the payback period according to the Alpha plc results is that the method of calculation is quite simply it did not take into effect several factors like the NPV or IRR factors such as cost of capital. Discounted cash flow methods and other things. Then a disadvantage of it is ignores very relevant data that will better in analysing the profitability of the project then also it does not take into value the time value of money in its calculation as seen it's a straight forward method

Accounting Rate of Return

It can also be called return on capital employed (ROCE), Penman (1991) describes ARR as simple the ratio of the income to the value of equity. Simply put the income derived divided by the average investment of the company. ARR is regarded as a traditional method as well as PP. The ARR for the investment will be 28.5%.

the decision is to accept the project since it is above the minimum rate required. The ARR as emphasized is a traditional method and there are several detriments of ARR according to the calculations made. One of the pros is takes into account the investment and also the income this are very vital to the calculation of the profitability as well as the liquidity in the sense that if the required rate of capital was higher than the ARR that indicates that it is not making a profit as well as its has liquidity issues, so by this its more explanatory and involve the most important figures in its calculation then one of the cons is the fact it does not take into value the cost of capital as well as it ignores the time value of money and time affects investment as well as profitability in d case of inflation this method might not be effective if the economy is not stable.

Recommendations and Conclusion

According to the evaluation that has been undertaken for this project it is therefore advised that the project should be taken since all the measure that has been undertaken for this project show reasonable analysis of both the profitability and liquidation of the project.

Ismail (2005) states in his article that the NPV and IRR are traditional methods of discounting they assume discrete cash flow and discrete cost of capital (discounting) which means that the information delivered might not be standard as it deals mainly with estimations and simplification. So these methods need the factual and real value of each figures so that when the computations are made in the computation of the value of the project it will yield to very ideal and close estimation of the actual outcome of the project

Drury (1997) also identified that in the 1992 the NPV and IRR techniques were used with the proportion of 32% and 44% while Pike (1975) the ARR and PP were used In the proportion 51% and 73% so this shows that a change in times of the methods. So NPV are IRR are more invoke as compared to ARR and PP. in 1992 the four methods were used in evaluation of project, it was very tedious but effective so my conclusion would be when evaluating the project all methods are to be used.