Budgeting Methods

Budgeting Methods

Net Present Value (NPV)

The Net Present Value in finance is the summation of present values of the individual cash flows in one entity. It is a time series of cash flows which are both incoming and outgoing. NPV is an important tool in discounted cash flow analysis since it is a standard method for the appraisal of long term projects using time value of money. It is also used for capital budgeting throughout finance, economics and accounting. NPV measures the shortfall or excess of cash flows in terms of the present value and above the cost of funds. Therefore, the method is appropriate since it makes proper use of all cash flows and tries to incorporate the time value of money. However, some companies find this method not applicable since it requires an appropriate rate of discount, which is difficult to obtain. The rate used to discount present value to future cash flows should be appropriate since it is an important variable in this process. NPV is relatively more difficult to explain. This is because the method has many computations, which some organizations may find to be more difficult to apply (Capital, 2012).

The Net Present Value method represents the dynamic investment appraisal and a cash flow method that is discounted. The basis for this method is the assumption that today’s euro is worth that tomorrow’s. The reason being that, today’s euro can be invested somewhere to generate interest. NPV method is appropriate for assessing new investments and comparing investment alternatives. The investment with the highest net present value is a more favorable alternative. Since it is an additive process, the investments net profit value can be summed up with the discount rates that are mutually unexclusive. The Net Present Value is obtained by adding up all discounted cash flows less expenditure on investments (Economic Feasibility Studies , 2010).

In a real world situation, an organization must decide on whether to introduce a new product in the market. The product will have various expenditures on the operations and start up and will have associated the incoming disbursements and cash receipts. Therefore, the project will have an initial cash outflow, which includes cash paid to machinery, transportation costs and disbursements on training employees. The project is estimated to cover the startup expenditures and step to a break-even point at the end of ten years. The present cash is therefore important since it would be better for an organization to invest in a project that will generate revenue in the future rather than do nothing with the money (Volkman, 2012).

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a rate of return that is applied in capital budgeting for measuring and comparing the investments’ profitability. The calculation does not incorporate the environmental factors such as inflation and interest rate. This method is a capital budgeting technique that is mostly used by many organizations.  Business people prefer the method because they like to see their results from the calculation in annual rates rather than actual dollar returns. This enables them to make comparisons of different projects for ranking. The ranking enables them to see the project that is going to provide more bang for the buck. The project with the highest rate of return on investments is the most advantageous for the organization. However, the method is more complicated to calculate by hand. Therefore, it requires the use of a scientific calculator or application of a spreadsheet (Research and Library Services:Northern Ireland Assembly, 2010).

IRR method is time consuming since it is more difficult to calculate by hand. The financial analysts spend extra time to identify and solve problems with the IRR. This may be due to the complications that may arise out of the method utilization when there is no pattern on the conventional cash flow. However, due to the intuitive appeal of the method, it becomes the most preferred in practical application of the techniques in capital budgeting.

One disadvantage of using IRR method is that it does not account for the size of projects when doing comparison. Cash flows are compared to the outlay capital, which generate them. This can bring trouble when different projects require different amounts of capital outlay, but the smaller project brings a higher IRR.  The method also ignores future costs and concerns itself with the projected cash flows, which are generated by a capital injection. Although IRR allows one to make calculations on future cash flows, it makes a wrong assumption that the cash flows can be invested again at the IRR rate. This assumption is not real since the IRR is a high number and the opportunities, which yield the return, are significantly limited or not available at all. Therefore, the Internal Rate of Return is not suitable for making comparisons of several investment projects that vary in amounts, timing and length. It is quite possible that the investment with a lower internal rate of return has a higher net present value than an investment with a higher internal rate of return (mary, 2011).

Budgeting Methods Dissertations
Budgeting Methods Dissertations

In a real world situation, a project with high internal rate of return should have a high net present value and the vice versa is also true. Organizations should therefore consider investing in big projects, which have high internal rate of return since it would be more advantageous for the organization.

Profitability Index

Profitability index is the investment ratio to the payoff of a suggested project. The method is a useful technique in budgeting in the grading of projects. This is because it measures the value recorded by every unit of investment that is made by the investor. The profitability index of a company’s investment indicates the benefits and costs of investing in a particular capital project by the firm. It is a cost-benefit ratio used in the financial analysis of capital budgeting. The method is useful in telling whether an investment increases the value of the firm or not. If the investment increases the value of the firm, more concentration and efforts are employed on it. On the other hand, if the investment does not increase the value, the firm may be tempted to withdraw its capital from the investment. The method considers all cash flows of the project and the time value of money. It is also useful in considering the risk of future cash flows through the cost of capital. Ranking and selecting of projects is also enhanced when capital is rationed. This allows the organization know the projects, which increases the value of the firm, and revenue generating projects. The method is important as it direct organizations on the areas where they should invest their capital and the risks involved (Dra, 2013).

One of the drawbacks of this method is that it requires an estimate of the capital costs for calculating the profitability index. The method may not give a clear decision when comparing projects, which are mutually exclusive. Therefore, it is not the appropriate method to measure the investment decisions of an organization since it lacks efficiency.

Many organizations direct their profits to investments with the target of getting extra revenues from those projects. The profitability index method is crucial in identifying the projects, which add value to the organization, as well as the dormant projects. Through the application of this budgeting method, an organization is able to focus on the highest revenue generating projects and to identify areas where more capital should be employed (Economic Feasibility Studies , 2010).

Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Returns (MIRR) is a financial measure of the attractiveness in an investment. It is a useful measure in capital budgeting to rank various investments of equal size. Also, the method is a discount rate that equates the present value of outflows to the future inflows value. This is a modified method of Internal Rate of Returns, and as such, its aim is to resolve the problems of the IRR. While the Internal Rate of Return assumes the projects’ cash flows are invested again at the IRR, the Modified Internal Rate of Returns assumes that positive cash flows are invested again at the cost of capital for the organization and the firm’s financial cost finances the initial outlays. Therefore, MIRR is a more accurate measure that reflects the costs and profitability of an organization’s project (Capital, 2012).

One of the advantages of this method is that it tells whether an investment increases the value of the firm. This is important for organizations to focus on the weaknesses of its investments. MIRR considers all cash flows in the project and puts in consideration the money time value. Just like other methods of budgeting, MIRR considers the future cash flows riskiness through the capital cost in the rule of decision. The Modified internal rate of return cannot be used for ranking order projects with different sizes. This is because a project with a larger modified internal rate of return may have a lower present value and vice versa. However, there are some variants, which exist for the modified internal rate of return that can be used to compare such projects (Research and Library Services:Northern Ireland Assembly, 2010).

One of the drawbacks of the Modified Internal rate of returns is that it requires the cost of capital estimates in order to make a decision. This may not be practical in an organization. The method may also not give the value maximizing decision when comparing projects, which are mutually exclusive. Lastly, the method may not give a decision when used to select projects in case of capital rationing.

Discounted Payback Period (DPP)

Discounted Payback Period is a procedure for determining the profitability of a project in a certain organization. In comparison to NPV analysis, which gives the project’s overall value, a discounted payback period indicates the length of time in years an organization would take to break even from the initial expenditure undertaken. Future cash flows are assumed to be discounted to time zero. This method has many similarities to payback period. However, the payback period is a measure of how long the initial cash flow would take to be paid back without taking into account the money time value. Discounted payback period is the time taken for the cash flows present value to recover the initial investment (Rogers, 2011).

This method is important since it puts into consideration the time value of money. Also discounted payback period considers the riskiness of cash flows of organization’s projects through the cost of capital employed. However,  there are no concrete criteria of making a decision which would indicate whether the investments increases the value of the firm. This means that the firm cannot identify the projects which adds value to the organization and might end up funding all projects including the dormant ones. The method also requires the capital costs to make payback calculations, which may not be available. Discounted Payback Period method ignores the cash flows that are beyond the payback period (Dra, 2013).

Projects with a negative net present value will lack a discounted payback period because the initial outlay will never be repaid fully. This is unlike the payback period the inflow from future cash flows could exceed the initial outflow. However, when inflows are discounted, a negative NPV is recorded.

Conclusion

NPV is a better and popular theoretical approach to capital budgeting based on several factors. Most important is that the Net Present Value use assumed that any cash flows that are intermediate generated by an investment are reinvested at the cost of capital for the firm. Due to the reasonable estimate of the cost of capital, at which the firm could invest its cash inflows, the use of NPV becomes a more realistic and conservative reinvestment rate in the preferred theory. In addition, certain properties of mathematics may cause a project with zero conventional cash inflow to have more than one IRR. The NPV approach does not have this problem (Capital, 2012).

References

Capital. (2012). Comparing Budgeting, 1-50.

Dra, P. P. (2013). budgetary methods. Advantage and disadvantages of, 1-2.

Economic Feasibility Studies . (2010). Capital Budgeting Techniques . Capital Budgeting Techniques , 1-8.

Mary, s. m. (2011). worklife resource ministry. budgeting methods, 1-3.

Research and Library Services:Northern Ireland Assembly. (2010). Research and Library Services. Northern Ireland Assembly, Research and Library Service, 1-30.

Rogers, M. (2011). Comparing Budgeting. Comparing Budgeting, 1-7.

Volkman, D. A. (2012). Journal Of Financial And Strategic Decisions. A Consistent Yield-Based Capital Budgeting Method, 1-88.

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Asset Price Bubbles

Central Bank Response to Asset Price Bubbles

Recent research in the area of macroeconomics has been focused on trying to identify the causes of the 2007 – 2008 global financial crisis and determining best central bank monetary policies to prevent future crises. A debate that has for the last few decades been settled is now being revived; “lean” versus “clean” handling of asset Price bubbles.

The prevailing consensus of central bank monetary policy has followed the “Greenspan Doctrine” established in the 1970’s for dealing with asset price bubbles. Alan Greenspan, who was the chairman of the U.S. Federal Reserve from 1987 to 2006, believed that cleaning up after an asset bubble burst was less costly and damaging to the economy than allowing central banks to burst bubbles; attempting to “Lean Against The Wind (LATW) (Wadhwani, 2008)” on rising asset bubbles to prevent a bigger burst. This perspective was widely accepted by central banks around the world.

There are mainly four arguments against LATW monetary policy. First, bubbles are difficult to predict; the market would likely detect asset bubbles before regulators would and the market would be able to orderly deflate those bubbles through natural market processes. Secondly, there is evidence that raising interest rates (a central bank strategy for determent) doesn’t reduce the inflation of bubbles since investors are likely to take the risk on high interest rate assets in the midst of an asset bubble based on the expectation of high returns on those assets. Third, the Fed is incapable of isolating dangerous asset bubbles from normal rising asset prices; monetary policy could ham-handedly attempt to prevent asset bubbles but have the effect of harming normal asset prices. Lastly, proactively bursting asset bubbles could make the burst harsher than if the bubble were allowed to burst on its own.

Those cautions have kept the Greenspan Doctrine in place since the late 80’s, but in the aftermath of the 2007 – 2008 crisis, many economists are beginning to wonder if the “lean” strategy may actually be cleaner than the Greenspan Doctrine. Not to mention, the Greenspan Doctrine assumed that bubbles could not be as destructive as the most recent housing bubble. Could central banks develop monetary policy strategies that are more precise in detecting and deterring asset bubbles?

Combating Price Bubbles

Clearly, setting aside the lean versus clean debate, there are standard monetary principles that have not always been followed or enforced. Namely, regulators should demand more transparent disclosure, require more capital and liquidity, apply stricter monitoring of risk, stronger enforcement of compliance, and more accountability for regulators charged with overseeing the financial stability of markets. These policies need to be either reinstated and or reinforced to help stabilize the markets during asset bubbles or otherwise.

But for central banks to devise better strategies for combating bubble driven asset pricing, it is necessary to rethink the Greenspan Doctrine considering how ill-prepared the central banks were for dealing with the crisis in the financial markets. Or, perhaps both strategies have a time and place in setting monetary policy. Frederic Mishkin argues that there is a way to apply the LATW strategy to the financial markets if first central banks understand that there are two different types of bubble driven assets and each one requires a different monetary strategy.

Asset-pricing bubbles are divided into “credit bubbles” – like the housing bubble – and “irrational exuberance bubbles” – like the dot-com bubble (Mishkin, 2011).” He argues that because credit bubbles are so destructive to the economy and so hard to clean up that it would be appropriate for central banks to focus their monetary policies on predicting and deflating credit bubbles before they grow too large. Credit bubbles are linked to the financial markets so intricately that whenever there is a credit bubble like the one just experienced, its bursting usually leaves in its wake a deep recession, a financial crisis and a long period of slow growth and high unemployment.

Asset Price Bubbles
Asset Price Bubbles

Unlike normal recessions, there was no sharp recovery after the last three big asset bubbles. Because it is so hard to recover from credit bubbles, trying to head them off and prevent them is necessary. The LATW can be applied and should factor in to central bank policy because credit bubbles are much easier to identify. Each credit bubble shares certain symptoms that could alert regulators to the problem: lower lending standards, premiums on risk become abnormally low and credit is being extended at a much faster and higher rate (Mishkin, 2011).

The central bank targets these credit bubbles by slowly raising interest rates to discourage excessive risk taking in the credit markets. By inflating the interest rates on these assets, central banks can tamp down exuberance as well as spark growth in a slowing economy (The Financial Times LTD, 2014). This requires central banks to turn their focus more sharply and aggressively towards monitoring and reacting to irregularities in asset pricing more than the traditional singular focus on controlling inflation (Wadhwani, 2008) (Gambacorta & Signoretti, 2013). Lastly, this type of proactive monetary policy could have the effect of reducing moral hazard through proactive responses to booms as opposed to the reactionary approach to booms after the bust; this could discourage the reckless risk taking that typifies credit bubbles (The Financial Times LTD, 2014).

While economists are still debating the merits of the LATW strategy of curtailing asset price bubbles, it is without question that the traditional standards of monetary oversight have been too lax over recent decades and reinforcing those policies will go a long way to restoring healthy checks and balances to the world market. However, it has also become very clear that these boom and bust cycles threaten financial stability in such a way that central banks can no longer ignore fluctuations in credit markets. While focusing on controlling inflation is still a target for central bank monetary policy, central banks must now focus efforts on developing Bubble Policies (Rudebusch, 2005) that can prevent or deflate asset price bubbles before they can do real damage to the economy

References

Brittan, S., Meltzer, A. H., Wolf, M., Smaghi, L. B., Schlesinger, H., Mayer, M. Frankel, J. (2009, Fall). Should, or Can, Central Banks Target Asset Prices? A Symposium of Views

Gambacorta, L., & Signoretti, F. M. (2013, July). Should monetary policy lean against the wind? – an analysis based on a DSGE model with banking.

Mishkin, F. S. (2011). How Should Central Banks Respond to Asset Price Bubbles? The ‘Lean’ versus ‘Clean’ Debate After the GFC. Reserve Bank of Australia June Bulletin, 59-67.

Rudebusch, G. D. (2005, August 5). Monetary Policy and Asset Price Bubbles.

The Financial Times LTD. (2014, April 16). Definition of leaning against the wind. Retrieved from Financial Times Lexicon: http://lexicon.ft.com/term?term=leaning-against-the-wind

Wadhwani, S. (2008). Should Monetary Policy Respond to Asset Price Bubbles? Revisiting the Debate. National Institute Economic Review, 25 – 34.

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