In making the accept/reject decision, each of the capital budgeting decision methods provides decision makers with...

 

Transcribed Image Text:

In making the accept/reject decision, each of the capital budgeting decision methods provides decision makers with a somewhat different piece of relevant information. Payback and discounted payback provide an indication of both the risk and the liquidity of a project NPV is important because it gives a direct measure of the dollar benefit (on a present value basis) of the project to shareholders, so it is regarded as the best single measure of profitability. IRR also measures profitability, but expressed as a percentage rate of return, which many decision makers prefer. Further, IRR contains information regarding a project's "safety margin." The modified IRR has all the virtues of the IRR, and it avoids the multiple rate of return problem. The PI measures profitability relative to the cost of a project-it shows the "bang per buck." Like the IRR, it gives an indication of the project's risk, for a high PI means that cash flows could fall quite a bit and the project would still be profitable. Quantitative methods such as NPV and IRR should be considered as an aid to informed decisions but not as a substitute for sound managerial judgment In a perfectly competitive economy, there would be no positive NPV projects-all companies would have the same opportunities, and competition would quickly eliminate any positive NPV. Positive NPV projects must be due to some imperfection in the marketplace, and the longer the life of the project, the longer that imperfection must last. Therefore, managers should be able to identify the imperfection and explain why it will persist before accepting that a project will really have a positive NPV. If you can't identify the reason a project has a positive projected NPV, then its actual NPV will probably not be positive. Positive NPV projects don't just happen-they result from hard work to develop some competitive advantage. Som e competitive advantages last longer than others, with their durability depending upon competitors' ability to replicate them. A number of studies regarding firm s' use of capital budgeting methods have been published. The general conclusion one can reach from these studies is that large firms should and do use the procedures we recommend, and that managers of small firms, especially managers with aspirations for future growth, should at least understand DCF procedures well enough to make rational decisions about using or not using them. Moreover, as computer technology makes it easier and less expensive for small firm s to use DCF methods, and as more and more of their competitors begin using these methods, survival will necessitate increased DCF usage. An important aspect of the capital budgeting process is the post-audit, which involves comparing actual results with those predicted by the project's sponsors and explaining why any differences occurred. The results of the post-audit help to improve forecasts, increase efficiency of the firm's operations, and identify abandonment termination opportunities. The post-audit is not a simple process-a number of factors can cause complications. Each element of the cash flow forecast is subject to uncertainty, so a percentage of all projects undertaken by any reasonably aggressive firm will necessarily go awry. Projects sometim e fail to meet expectations for reasons beyond the control of the operating executives and for reasons that no one could realistically be expected to anticipate. It is often difficult to separate the operating results of one investment from those of a larger system. It is often hard to hand out blame or praise, because the executives who were responsible for launching a given long-term investment may have moved on by the time the results are known The results of post-audits often conclude that (1) the actual NPV s of most cost reduction projects exceed their expected NPV s by a slight amount, (2) expansion projects generally fall short of their expected NPV s by a slight amount, and (3) new product and new market projects fall short by relatively large amounts. The best-run and most successful organizations put great emphasis on post-audits. Let's continue Discussion on this topic In making the accept/reject decision, each of the capital budgeting decision methods provides decision makers with a somewhat different piece of relevant information. Payback and discounted payback provide an indication of both the risk and the liquidity of a project NPV is important because it gives a direct measure of the dollar benefit (on a present value basis) of the project to shareholders, so it is regarded as the best single measure of profitability. IRR also measures profitability, but expressed as a percentage rate of return, which many decision makers prefer. Further, IRR contains information regarding a project's "safety margin." The modified IRR has all the virtues of the IRR, and it avoids the multiple rate of return problem. The PI measures profitability relative to the cost of a project-it shows the "bang per buck." Like the IRR, it gives an indication of the project's risk, for a high PI means that cash flows could fall quite a bit and the project would still be profitable. Quantitative methods such as NPV and IRR should be considered as an aid to informed decisions but not as a substitute for sound managerial judgment In a perfectly competitive economy, there would be no positive NPV projects-all companies would have the same opportunities, and competition would quickly eliminate any positive NPV. Positive NPV projects must be due to some imperfection in the marketplace, and the longer the life of the project, the longer that imperfection must last. Therefore, managers should be able to identify the imperfection and explain why it will persist before accepting that a project will really have a positive NPV. If you can't identify the reason a project has a positive projected NPV, then its actual NPV will probably not be positive. Positive NPV projects don't just happen-they result from hard work to develop some competitive advantage. Som e competitive advantages last longer than others, with their durability depending upon competitors' ability to replicate them. A number of studies regarding firm s' use of capital budgeting methods have been published. The general conclusion one can reach from these studies is that large firms should and do use the procedures we recommend, and that managers of small firms, especially managers with aspirations for future growth, should at least understand DCF procedures well enough to make rational decisions about using or not using them. Moreover, as computer technology makes it easier and less expensive for small firm s to use DCF methods, and as more and more of their competitors begin using these methods, survival will necessitate increased DCF usage. An important aspect of the capital budgeting process is the post-audit, which involves comparing actual results with those predicted by the project's sponsors and explaining why any differences occurred. The results of the post-audit help to improve forecasts, increase efficiency of the firm's operations, and identify abandonment termination opportunities. The post-audit is not a simple process-a number of factors can cause complications. Each element of the cash flow forecast is subject to uncertainty, so a percentage of all projects undertaken by any reasonably aggressive firm will necessarily go awry. Projects sometim e fail to meet expectations for reasons beyond the control of the operating executives and for reasons that no one could realistically be expected to anticipate. It is often difficult to separate the operating results of one investment from those of a larger system. It is often hard to hand out blame or praise, because the executives who were responsible for launching a given long-term investment may have moved on by the time the results are known The results of post-audits often conclude that (1) the actual NPV s of most cost reduction projects exceed their expected NPV s by a slight amount, (2) expansion projects generally fall short of their expected NPV s by a slight amount, and (3) new product and new market projects fall short by relatively large amounts. The best-run and most successful organizations put great emphasis on post-audits. Let's continue Discussion on this topic

Answer rating: 100% (QA)

Answer 1 Payback and discounted payback provide an indication of both the risk and the liquidity of a project Payback period is the time period required to recover the initial outlay of a project from ... View the full answer