BUS 5110 Unit 6 Portfolio Assignment: Analytical Tools for Capital Budgeting Decision

Ubong Akpekong
S261953
University of the People
The following analytical tools can be used in capital budgeting decisions

- Accounting Rate of Return

ARR is the return on initial outlay or return on average capital. It is calculated, using the

formula:

ARR = Average Annual Accounting Profit/Average Investment

Where average investment is: initial investment + residual value/ 2.

ARR considers the profits of a project throughout its useful life and is simple to calculate and

understand. It also facilitates expenditure follow-up due to more readily available data on

accounting records. However, it does not take into account the time value of money and also

it ignores the fact that profits from different projects may accrue at an uneven rate, hence, It

fails to cater for risks and uncertainties. (Javed, 2021)

- Payback Period Method

The payback period method focuses on the time taken by an investment to recoup the amount

of initial cash put into it. The shorter the pay-back period, the more preferable the project is.

A project will be undertaken only if the payback- period is shorter, or at worst, equal to the

maximum set standard period. For a single project, the pay-back period is compared with a

set standard. For mutually exclusive projects, they're ranked and therefore the one with the

shortest pay off time is chosen . Though this method is a useful measure of liquidity, since

the method ensures the selection of projects that provide the hope of immediate cash

recoupment, it does not also take into account the time value of money. (Heisinger)
- Net Present Value

The NPV method refers to the equivalents in present value terms of the cash inflows and

outflows from a project when discounted at a particular or given cost of capital. The

appropriate discount rate chosen is one firm’s or Corporation’s cost of capital, which is

adequate to the specified rate of return. The decision criterion is that a project is suitable if it's

a positive NPV, and rejected, if it's a negative NPV. In total, this value of money inflows

should be greater than that of money outflows. (Lumen Learning. , n.d.) The positive nature

of internet present value pre-supposes the potential increase in consumption made possible by

the investment, valued in present day terms. For mutually exclusive projects, they might be

ranked. The one with the very best net present value is chosen . The good thing about this

method is that cash flows on the entire lives of the projects are taken into consideration.

However, it works with the assumption that the cash inflows will come as predicted which

may not necessarily be so. (Javed, 2021)

Analytical tools that provide the best information and the least beneficial information:

From the discussions above, I believe that the NPV provides the best information as this tool

uses cash flows on the entire lives of the projects and the time value of money is also adjusted

for in the computation of NPV.

However, on the flip side, the Payback period provides the lease information as not all cash

flows are considered and the time value of money is not also considered.

REFLECTION:

In the course of this week’s study, I learnt so much about investment appraisal, the risk

involved in capital budgeting and the different techniques of carrying out an investment

appraisal both the normal method and therefore the modern method.
In my readings, I discovered that the preparation of capital budgets and taking investment

decisions involves a lot of processes starting with assessing the various risks associated with

different courses of actions both finance risk, operational risks and other risks, carrying out

asensitivity analysis on the projects and appraising each project on their profitability and

viability. (The Institute of Chartered Accountants of Nigeria (ICAN), 2014)

The discussion assignment we had really exposed me to reading about Investment appraisals

and their associated risks, I read and discussed with colleagues on the most important risk

that mustbe considered in risk assessment.

My reading also disclosed a term called Sensitivity Analysis which simply means carrying

out a what if this or that happens analysis, I also read about capital rationing which is the

process of sharing the available limited capital among different viable projects.

This week’s studies have really served as an eye-opener for me as I will apply the acquired

knowledge in my very small farm accounting and livestock production, by not expanding

without carrying out adequate investment appraisal and risk assessment.

REFERENCES
Heisinger, K. &. (n.d.). Accounting for managers.
Javed, R. (2021, December 01). Accounting for Management. . Retrieved from Variable,
fixed and mixed (semi-variable) costs. :
https://www.accountingformanagement.org/variable-fixed-and-mixed-costs/
Lumen Learning. . (n.d.). The Relationship Between Risk and Capital Budgeting. . Retrieved
from courses.lumenlearning.com: https://courses.lumenlearning.com/boundless-
finance/chapter/the-relationship-between-risk- and-capital-budgeting/
The Institute of Chartered Accountants of Nigeria (ICAN). (2014). In Performance
Management (pp. 339-342). Emile Woolf International.