Author: Marissa Lee
Date: 30 December 2016
Caption: Some Types of Investment Criteria in Capital Budgeting
This article relates to the topic of capital budgeting. Capital budgeting means the process of determining and evaluating potential expenses or investments that are large in nature. To put it simpler, capital budgeting means the investment on long-term assets. It usually includes predicting the company’s future profit & cash flow by period, present value of cash flows after the “time value of money”, etc. Thus, Capital budgeting will come in handy when deciding on whether to purchase an asset as a company would need to predict the revenue over the life of that particular asset.
There are 3 most common capital budgeting approach; Net Present Value, Internal Rate of Return and Payback Periods Method.
Net Present Value is the difference between the current value of cash inflows and the current value of cash outflow.
Payback Period helps the company to estimate the time that is required for them to fully cover their initial investment cost. Companies usually find this approach much easier to use when they already have their predicted their cash flows.
In this news article, they talk about how Small Medium Enterprises in Singapore has very little chances to succeed. This is because due to the fact that they are a start-up itself, being sustainable or having the revenue to keep them afloat is difficult. As seen from this article, it states that “SMEs often struggle with investment costs due to their lack of scale”. Since they are a start-up, they would find it challenging to predict their profit or loss in the upcoming years, thus when handling more than one project or assets, there will be a challenge for them in recouping their initial investment costs. Maybe one approach the company should take before investing is to use the payback period to estimate the time where they are able to recoup their investment costs so they would not be struggling so much with it. This way, they will be able to focus on recovering their initial investment costs first before moving on to purchase another asset or starting on a new project. However, there might be a problem with this approach too, as using the payback period approach, it does not take into account for the time value of money. This can also imply that $1 in the current day might equals to more than a dollar in the future and this might not be the most accurate tool to measure if it is worth investing in the asset. A more accurate tool might be the discounted payback period, whereby time value of money is taken into consideration.
Also in this article, there are also several SMEs who are confident that they will gain something out of something that they invest in. For example, one company that is stated in the news article actually invested $650,000 into equipment enhancement. This confidence can be obtained by using one of the capital budgeting approach which is the Net Present Value (NPV). As said above, Net Present Value is the difference between the current value of cash inflows and the current value of cash outflow. Net Present Value can be calculated by comparing the initial cost of the asset or project to the total value of future revenue the asset or project will give. Using the Net Present Value, the asset or project will only be proved worth doing when there is a positive net present value. This can be achieved by lending from banks or having bonds in order to balance out the total revenue gained from the asset plus the cost of the asset itself.
However, there might be some hiccups along the way as NPV are usually based on assumptions and estimates so the forecasted positive NPV might not necessarily be achieved, which might lead the business to a loss instead.