FINANCIAL DECISION MAKING

Financial decision making

Financial decision making

A) Valuation methods

In current environment, where competition is at its peak a firm seeking for similar opportunities finds it difficult to attain. However, capital financing projects can be categorized into three broader categories. First a capital project can be related to revenue enhancement. Secondly a capital project is categorized in cost reducing investments. Lastly, a capital project is considered when there is mandate by government or other bodies (Besley & Brigham, 2007, pp 115-125). Various methods to evaluate capital budgeting are further discussed below.

Payback period

Payback period refers to capital budgeting concept in which period is calculated that recover the original investment of the project (Besley & Brigham, 2007, pp 115-125).

Discounted payback period

Discounted payback period is similar to payback period except it takes present value of cash flows rather than future values as used in payback method (Besley & Brigham, 2007, pp 115-125).

Net present value

Net present value (NPV) refers to the difference between discounted cash flows (inflows minus outflows). Project is considered attractive if the NPV of the project is positive. On the other hand, NPV with negative value refers project returning value is below the investment in current state of time and hence leads to rejection of the project (Besley & Brigham, 2007, pp 115-125).

Internal rate of return

Internal rate of return refers (IRR) is used in evaluating capital project and compares profitability of different or single alternatives. Internal rate of return is computed in percentage and higher percentage refers to more profitable investment (Bender, 2009, pp 50-53).

Modified internal rate of return

Modified internal rate of return (MIRR) improves the IRR and considers reinvestment during the project and provides better picture (Bender, 2009, pp 50-53).

Profitability index

Profitability index calculates the relationship between the benefit and cost of the capital project. It is computed by PV of cash flows divided by initial investment (Damodaran, 2010, pp 165-170).

Asset valuation

In asset valuation method the worth of the business is evaluated and it is also used to assess the value of security, real property, antique items or any other item that has some worth. This method is used before sale or purchase of specific asset.

B) Limitation of valuation method

Payback period

Advantages of payback period are:

It is easy to compute payback period and person having minimal knowledge of accounting can also use this tool.

It provides timeline in which project will be repaying its initial investment.

Some disadvantages of payback period are as follows:

Payback period method does not undertake time value of money factor and thus does not provide clear information of the business or project.

This method is more focused on initial investment recovery and does not look for the inflows after the payback period and therefore project is not clearly evaluated in term of profitability.

This method does not provide decision criteria for investor regarding business's value enhancement (Besley & Brigham, 2007, pp 115-125).

Discounted payback period

Advantages of discounted payback period are as follows:

In valuation decision, this method considers time value of money factor into account while evaluating project by cost of capital which ...