Accounting Capital Accounting and Budgeting Questions NPV Essay

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Accounting

Capital Accounting and Budgeting Questions

NPV

When a firm has different potential projects or investments, they will want to assess their options to ensure they make the best choice. However, comparing different types of projects or investments can be difficult, especially if the projects have different terms to maturity and/or different risk profiles. A useful tool is that of net present value (NPV). Net present value allows different types of project to be compared on a like for like basis.

The net present value calculation takes all of the forecast future net cash flows of a project (the revenue less all the costs), and then discounts them into today's value. The discounting allows the firm to assess what the value of the future cash flows will be in today's money. The rate of discount applied will usually be the cost of capital for the firm, but where there is a high level of risk, this may also be adjusted to allow for a risk premium (Arnold, 2012). The calculation will result in a final figure, which is the total of the net discounted cash flow for each year, less the initial investment. By presenting a single figure to be assessed there is an easy basis for comparison. It is worth noting this process is biased towards sort term results, as the compounding of the discount rate has a greater impact on longer term results (Arnold, 2012).

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It may also be difficult where there are projects that are significantly different in terms of size, as it only gives a final monetary value, and no indication of efficiency (Arnold, 2012).

An alternate approach may be the calculation of the internal rate of return (IRR). This is based on an NPV calculation, but instead of giving a single monetary figure, the result in the expected internal rate of return that each project will provide for the firm, allowing for the assessment to be based on the return that the firm requires (Atrill, 2011). However, it is worth noting that while the NPV result does not require an assumption regarding reinvestment of funds, with the IRR there is an underlying assumption that the funds realized will be reinvested at the same rate; an assumption which may not always be accurate or even viable (Atrill, 2011).

Part 2 - Capital Budgeting

Capital budgeting may be impacted by a number of risks, some of these can be considered individually, but it is worth noting they will often manifest in an interdependent manner.

Exchange rate risk

Where investments are made in a difficult country, or loans are taken out in a….....

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