Models of capital projects are one of several techniques employed in measuring value in long term investment projects. As such, firms invest in the capital project to augment production in order to meet the demand. Tentatively, companies invest in the capital projects for a number of non economical reasons that include converting to a human resources database to meet the government regulation and installation of pollution control as well. As such, these paper centers on various capital project methods as well as differentiate the process in retrospect to investment.
Simple Payback Method
The payback method is a measure of time needed to pay back the preliminary investment of a project. Undoubtedly, the method regards the preliminary investment cost as well as the resulting annual cash flow. Nevertheless, the method does not account for the saving that progress from the initial investment. Per se, the method is efficient for “firstcut” project analysis.
The method incorporates various strategies:
1. Payback with Equal Annual Savings
In this case where the cash flow is equal, the payback period is obtained by dividing the initial investment by the annual savings
2. Payback with Unequal Annual Savings
There exists significant cost that would cause imperative costs like taxes and depreciation that results to varying cash flow. As such, in the case where the cash flow differs annually, the payback period is obtained when the initial investment is equal to the accrued savings-zeroes cumulative cash balance.
The conventional IRR is extensively incorporated in the assessment of projects that suffers from the assumption of investment at the rate of IRR. As such, IRR is a measure of safety that permits for investment return evaluation in comparison to the risk. As a result, if the IRR of 0.3 when the needed return is 0.12, it depicts a large error of margin .As opposed to NPV, the IRR offers the same type of management information. In India, for example, IRR prevails as it’s attributed to its ease of handling characteristics. In isolation, the system is efficient in the timing of cash flows as well as multiple internal rates.
NET PRESENT VALUE
NPV is a traditional analysis of a project’s long term cost. As such, it sums up each year’s cost or benefit so that the total benefit is the sum of each year’s benefit. In capital project evaluation, it necessitates that the investment cost (a cash outflow usually in year 0) be contrasted with the net cash inflow that arise many years to follow. Notably, the cash flow is not comparable due to the time value of money. However, money received in the future will have to be discounted by appropriate rates of percentage, usually the prevailing interest rate. The present value is the value in current dollars of payment streams that can be calculated using the following criteria.
Nonetheless, the flaws of the method is that it assumes that dollars in years to come have the same value as the present dollar. For instance, a $100 savings bond that matures in 10 years signifies $100 in the future; nevertheless, the saving is worth less that a $100 bill presently.
Notably, as IRR an NPV is preferable procedure, they differ greatly. As such, the IRR recommendation for reciprocally exclusive investment is less reliable in retrospect to the NPV method application, as the former fails to consider the investment size. For instance, considering a company’s investment whose discount rate is 10%: Investment P requires an outlay of $10000, with $12000 cash proceedings. Investment S has an outlay of $15000, and the cash proceeds of $17700, the preceding year. As such the IRR of P is 20% whereas S is 18%.
As such P is more desirable based on the hypothesis that the higher the IRR the better the investment. In basing this consideration, size of investment is left out. As such, the difference between P and S is an addition $5000 outlay that provides proceeds for $5700.
Also known as profit investment ratio (PIR), the Profitability ratio is the ratio of investment payoff of a project. Nevertheless, it can be defined as the ration of the present value of benefits (PVB) to the present value cost (PVC). As such, it is a helpful tool for ranking the projects as it permits quantifying created value per unit of investment.
Tentatively, it can be calculated by dividing the present value of future cash flow that is anticipated to be generated by the capital projects. As such, if the result is less than 1.0, you do not invest in the plan. On the other hand, if the profitability index is greater than one you invest in the project. Undoubtedly, if the profitability index of a stipulated project is 1.2, you will expect a return of $1.2 for every $1.00 that you invest in the project. Contrastingly, the profitability index is often used in ranking a firm’s possible investment projects. Certainly, as many companies have limited financial resources, they invest in the most profitable venture.
The profit index may as well be used as a monitoring tool for the economic performance of a process that offers the profit as a pecuniary value if the deviation standard is approximated. A drawback, nevertheless, is that, as a substitute of quadratic functions for performance functions, error and exponential functions have to be executed for profit index.
Effects of volume increase in sales
Sales variance is the notable difference between budget and actual sales. Generally, it is indispensable in determining performance of the sales function and in the analysis of business results in order to have a better comprehension of market demands.
Undoubtedly, increasing in sales volume implies the capability to meet various market demands, thus, guaranteeing an increase in profit amounts. In some cases, augmenting volume can be realized by a reduction in commodity price. As such, it would only be effective if the customers are price sensitive.
Moreover, increase in the price of commodities also has an effect on sales. The price of products is an indispensable factor that determines profits. Appealing markets reasons should be considered before augmenting prices of commodities, as such to better suit or sustain the clients. Nevertheless, an increase in the price of products may at times lead to decrease in sales due to reduced levels of customer affordability. However, in other cases it may lead to an increase in the gross profit acquired depending on the level of market competition. Net income is the gross annual income after all the operating expenses are cleared but before income adjustments are made to cover, interest payments, income taxes or any amount of depreciation where applicable.