Capital budgeting is used by firms’ management to make investment decisions by analyzing available options and determining the investment project that most fit firm’s objectives and goals and those that provide the highest return. Management makes their final investment decisions based on five characteristics: project size, benefit to the firm, degree of dependence, degree of statistical dependence, and type of cash flow (FAO.org, n.d.). To evaluate the potential benefit of investment projects, managers may use various capital budgeting methods. The methods used by Futronics’ managers to determine the benefits of replacing some of its central office stores with outside vendors are net present value (NPV), internal rate of return (IRR), and simple payback. The NPV and IRR are similar methods because they are time adjusted to measure profitability and they are calculated using similar formulas (FAO.org, n.d.). The payback method is simple because firms just use it to determine the amount of time it will take to recover their initial investments. Each method was used to calculate the effect of Futronics’ potential cash flows for the $1 million investment and is presented below.
When using the NPV and IRR, management determines the viability of investments by basing their decisions on the results meeting or exceeding a pre-established amount or rate. As displayed above, the NPV of the investment is $138,642, which indicates that the firm will generate a profit of approximately 13.9 percent. The IRR for the project is estimated at 14.79 percent; and under the simple payback period method, the firm will receive their initial investment back some time in year 3 or approximately within 2.67 years. The NPV rule suggests that a firm reject projects that result in negative NPV and accept those with positive NPVs; the IRR rule suggests accepting projects with an IRR that exceeds a specified rate and rejecting those that are less than the rate (Bosch et al, 2007). The simple payback method rejects investments where the initial investment is not recovered before the cash flow period ends. As indicated in the reading, the firm’s cost of capital is 8 percent. If the firm used the cost of capital (8 percent) to determine if the project should be rejected or accepted, the project should be accepted because the IRR exceeds this amount with 14.79 percent. It should also be accepted using the NPV because it results in positive cash flows; the payback period results would also lead to an acceptance because the firm will recoup its initial investment before the cash flows end.
Futronics could likely gain multiple benefits from outsourcing the company’s central office stores with outside vendors. One benefit is that it could improve the firm’s current sales levels. The reading states that the firm’s flat sales, competition, and economic conditions have led management to implement a corporate overhead reduction program. Since outsourcing will result in positive cash flows and the firm yielding returns that exceed its minimum requirements, it could benefit from partaking in this project.
Of the three capital budgeting methods discussed, the most advantageous method is the NPV and the least advantageous method is the simple payback method. The NPV method is advantageous because it considers the full life and size of projects; considers the time value of money; yields homogenous payback coefficients; and uses a preset rate of return based on a firm’s acceptable standards reducing the guest work that is associated with the IRR method (Bosch et al, 2007). The payback method is not advantageous because it does not consider the time value of money; it places less emphasis on shareholders’ interest; and it ‘partially captures the resolution of uncertainty surrounding [a] project’s outcome’ (Chen & Zhu, 2004, p. 42).
- Bosch, M., Montllor-Serrats, J., & Tarrazon, M. (2007). NPV as a Function of the IRR: The
Value Drivers of Investment Projects. Journal of Applied Finance, 17(2), 41-45.
- Chen, S., Dodd, J., & Zhu, Z. (2004). AN EMPIRICAL STUDY OF THE USE OF PAYBACK
ETHOD: OPPORTUNISTIC BEHAVIOR OR EFFICIENT CHOICE. Journal of Accounting & Finance Research, 12(4), 40-53.
- FAO.org,.’Chapter 6 – Investment decisions – Capital budgeting. Retrieved 7 March 2015, from http://www.fao.org/docrep/W4343E/w4343e07.htm