Usefulness of Capital Investment Techniques - 550 Words

Usefulness of Capital Investment Techniques (Other (Not Listed) Sample) Content: Usefulness of Capital Investment Techniques Name Institution Memorandum From: To: Subject: Usefulness of Capital Investment Techniques Capital Investment Appraisal techniques are used to evaluate the financial feasibility of capital investment projects. The techniques are broadly classified into two categories namely; Non Discounted Cash flow techniques and Discounted Cash flow techniques (Khan Jain, 2007). Discounted cash flow methods incorporate the concept of time value of money in their operation. The Time value of money principle posits that cash flows into the future have less value as compared to current cash flows. Discounted cash flow methods therefore restate future cash flows to their current values at a predetermined discounting rate and thereafter use these discounted cash flows in appraising the financial viability of a project. Non Discounted cash flows methods do not involve the use of the Discounting principle. This Memorandum covers the various capital investment techniques by discussing their advantages and limitations. The Memorandum also addresses a case analysis of Southern Power and Light whi ch is considering two projects. The common discounted cash flows techniques are; the Net Present Value (NPV) and the Internal Rate of Return (IRR) ( HYPERLINK "/search?tbo=ptbm=bksq=inauthor:%22Uwe+G%C3%B6tze%22" GÃÆ' ¶tze, Northcott Schuster, (2015). The Net Present Value method determines the present value of a projectà ¢Ã¢â€š ¬Ã¢â€ž ¢s future cash flows. The Initial investment and other present value costs are then subtracted from the present value of the future cash inflows. The residual value is called the NPV. If the NPV is a positive value, the project is accepted whereas if it is a negative value the project is rejected. This method presents the following advantages; it recognizes the time value of money by incorporating the discounting principle, it gives a clear decision criterion of when to accept or reject a project, and it incorporates risk in capital budgeting by using a discounting rate. The method has a major limitation in comparing projects of dissimilar sizes. The Internal Rate of Return (IRR) is the rate that equates the Net Present Value of a project or an investment to zero. The IRR decision criteria recommends that if a projectà ¢Ã¢â€š ¬Ã¢â€ž ¢s IRR is greater than the Required rate of return (discounting rate) then such a project should be accepted whereas if a projectà ¢Ã¢â€š ¬Ã¢â€ž ¢s IRR is less than the required rate of return the project should be rejected. The IRR shares similar advantages with the NPV in the sense that it incorporates risk and recognizes the time value of money through the discounting principle. However the IRR has one major flaw in its assumption that the projectà ¢Ã¢â€š ¬Ã¢â€ž ¢s future cash inflows are reinvested back in the project at its own IRR. This is not usually the case because the discounting rate is determined by the market conditions. Secondly in cases of nonlinear cash flows there is the possibility of multiple IRRs which can be hard to analyze. The common non discounted capital investment appraisal techniques include the Payback method and the unadjusted rate of return. The payback method calculates the period it takes for the project to repay its investment. This method has an advantage in the sense that it prefers a project with higher cash flows at the beginning thereby recognizing the risk in future cash flows. The method has a limitation in the sense that it does not use the discounting principle. The unadjusted rate of return also called Accounting Rate of Return divides the average income with the average investment. This method is easy to comprehend especially by accountants. However it suffers the limitations inherent in the calculation of accounting profits which include numerous assumptions (Tarantino, 2010). The Southern Power and Light Case    Year Wind Turbines Bio Fuel Equipment 0 (971,840) (1,109,500) 1 320,000 350,000 ...