International Accounting Standard 2

International Accounting Standard 2

The criteria to record and recognize the inventory is also explained as instructed under International Accounting Standard 2. Inventory is separated from the Non-Current Assets like plant and equipment which are held for sale at maturity and a further categorization of inventory is given in two forms like By-Products and Main products. The item which is normally sold out by the companies through ordinary course of its activities are termed as Inventory.

Generally three forms of inventory are founded in any manufacturing companies which are Finished Products, Raw Material and Work-In-Process. All three inventories have different cost classifications and nature and should be measure on separate basis. There are four cost formulas to measure the inventory and are generally practiced in the US. Four formulas are LIFO, FIFO, Weighted Average Method and Specific Identification. This also explains the concept at which the reporting cost of the inventory is provided and Inventory should be reported at lower of Cost or Net Realizable Value (NRV). Cost is the value at which the inventory is purchased including purchase cost, carriage inwards and other taxes paid on the purchase whereas the Net Realizable Value id the amount at which the inventory can be sold out in the market less any expected expenses to complete the sale process.

International Accounting Standard 2 is one of the Accounting Standards issued by the Accounting Standard Committee to record and measure the financial items pertaining financial features. International Accounting Standard 2 encompasses the recording and measurement of Inventory. Inventory is defined in the International Accounting Standard 2 as assets which are held for sale in the ordinary course of activity by the company and it comprises Finished Products, Raw Materials and Work-in-Process. Inventories are the goods manufactured by the company in order to obtain the economic benefits from the sale to the customers. The main objective of the issuance of this standard is to separate the Non-Current Assets of the company from the inventory which is a Current Asset.

International Accounting Standard 2 Adoption

Prior to the interpretation of International Accounting Standard 2, most of the companies have faced problems in the identification and recognition of the inventory and commonly the estimation and recording of the cost of inventory was a key concern for them. International Accounting Standard 2 has led the management to maintain and report the inventory at the reasonable and appropriate value. International Accounting Standard 2 defines the items of Inventory along with the methods to record the inventory. The methods which are being interpreted under International Accounting Standard 2 are FIFO, AVCO and LIFO.

First in First Out (FIFO) is the method which explains that the oldest inventory should be sold out first and then the next one whereas the Weighted Average Cost Method (AVCO) means the inventory should be recorded by calculating the average cost of available inventory and then multiply this with the number of units in stock. Last in First Out (LIFO) is a method which is not being used currently because of some drawbacks attached to it as it promotes the system to sale the most recent purchases to be sold out prior to sale the old inventory. This Standard provides detail of each and every feature associated to the inventory and how to deal with that.

Methodology

Due to the misappropriation of inventory there was a need to guide the companies as to record the inventories properly. This is why the International Accounting Standard 2 was issued and interpreted in a detailed way. If the company is involved in the sale and purchase of something then it is likely to hold inventory which can be in the form of Raw Materials, Finished goods and Work-in-process. Theoretically everything which is held for sale is termed as inventory but the question rises that either the plant and machinery held for sale are also termed as inventory then the answer would be ‘No’.

Everything which is sold out through ordinary course of business is termed as sales and purchases eventually known as inventory. So the Non-Current Assets are not classified as Inventory under IAS 2. There are further 3 techniques are issued under this standard to record the inventory and inventory handling. First in First out (FIFO) is a method which tends to sale the oldest unit of inventory first and it makes sense as it would reduce the threat of inventory obsolescence. Weighted Average Cost Method (AVCO) is method which uses an average cost for all the units of inventory and records the inventory on this basis so there is no separation of recent and old purchases.

Last in First out (LIFO) method promotes the sale of most recent purchases and there are more chances of obsolescence of inventory. Apart from these techniques the cost recognition criteria is also listed in this standard. As per International Accounting Standard 2, inventory should be recognized at lower of Cost or Net Realizable Value (NRV). Net Realizable Value is the value at which the inventory can be sold in the market or simple the market value. Theoretically this is the fair value concept and more appropriate to record the assets as it would lead to a fair appropriation of the assets of the company and no chance of being misled.

Literature Review

International Accounting Standard 2 defines the criteria to record inventory. And as such, inventory should be recorded at lower of Cost or Net Realizable value (NRV). Cost is the amount at which the Inventory is being purchased initially and whereas the NRV is the amount at which inventory can be sold out. Net Realizable Value is the amount of cost less any expenses required to make inventory into a saleable state. Though there are some problems in the recognition of inventory because there are three types of inventories in a company which are subject to value at the most appropriate amount before recognition.

Finished goods are required to be valued so that it can be recorded at lower of NRV or Cost as they do not require any further assessment criteria but Work-in-Process requires some extra work to make an appropriate valuation of inventory. There is a need to consider that how much material has been incurred to the product till that date and how many labor hours has been spent on the product. There is also a further calculation of overheads cost as to how much overheads should be allocated to the Work-in-process units as they are not yet completed so there is a need to calculate the amount of overheads.

Generally the overheads are absorbed by the companies by using labor hours but mostly companies also use the machine hours as the absorption base. So this can ease the calculation of overheads allocation just simply cost of labor per hour multiply by the number of labor hours or machine hours incurred to the product. Generally the wastage costs, idle labor hours, storage costs and other costs like these are also included in the product cost.

In most of the production processed two type of products are produced in a single process and are named as Main product and By-Product. By-products are the products which are produced unintentionally as these are not the ordinary items of the company for sale purposes but these should also be recorded as inventory because the economic benefits are expected to flow to entity from the sale of these products and the cost of such products can be measured at the joint process phase of production.

International Accounting Standard 2
International Accounting Standard 2

After the recognition of per unit cost, there are some formulas for the inventory valuation generally practiced in the US. LIFO, FIFO, Weighted Average Method and Specific Identification. Under IFRS and US GAAP all these formulas are same but the practice of some formulas are limited across the world due to the drawbacks attached to them and these methods are LIFO and Specific Identification.

Main drawbacks to LIFO are much more in general as it promotes the threat of Inventory obsolescence and more risk in the incorrect valuation of the inventory. Due to this reason LIFO is discouraged across the world and now Weighted Average Method and FIFO are used extensively. In the past most of companies used the LIFO as their tax shields to reduce the profits and other manipulations but after the consideration of such issues the application of LIFO is now restricted and now limited to some states only.

There are some costs which cannot be the part of inventory in any case and they should be reported as an expense to the income statement. Most common examples of these costs are:

  • Abnormal Wastage of material
  • Abnormal Idle hours of Labor
  • Abnormal overheads due to the Abnormal Idle Hours
  • Reduction in the Net Realizable value of the inventory
  • There are some handling costs which are not important for the product but incurred and these should not be measured in the inventory cost as well
  • Admin expenses and other costs associated to admin department

International Accounting Standard 2 Conclusion

This research provided a complete detail of the International Accounting Standard 2. The complete criteria and detail of the inventory recognition and measurement criteria is explained in this assignment. The measurement of the inventory is based on the management’s perception but with the introduction of this standard, all the criteria and relevant aspects have cleared.

Management is guided thoroughly on the measurement of inventory and the recognition of the inventory instruments as to remove the ambiguity between the inventory and other assets of the company. Management has four different formulas to record the cost of the inventory and the most practical and generally accepted formulas are the FIFO and weighted average method. Management should use the cost formula among both of these as these are the recommended and practically accepted under IFRS and US GAAP.

There would not be any problem in the inventory measurement if these rules are followed. Management is required to differentiate the By-products and Main products as both of these have different characteristics and benefits and need to be separately identified. The relevant cost should be ascertained to the inventory whilst the other should be charged to the expenses like abnormal wastage and labor cost etc.

International Accounting Standard 2 Relevant Posts

Theories of Finance

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Cost of Capital

Finance Project Cost of Capital Halfords Group

The theory of cost of capital

Cost of capital is dependent on the risk that has been taken by a company. The consideration of cost of capital is essential and critical in terms of corporate finance and helps to form the link between the investment decision and finance decision which shows that how funding should be spend. It is necessary for the company to have a control over its capital structure as according to a theory when more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases (Arnold, 2005). The impact of capital cost on making capital investment decisions is that the company is making investments with similar degrees of risk and if a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change (Brealey, Myers, & Allen, 2006).

Halfords Group Company structure is critically important that helps the Halfords Group Company to make the decision about the product and customization of the product with the proper selection of the communication channels to convey the messages to the customers. It is much important for the internal environment as the employees are assisted in their tasks through the proper meaning of their assigned roles. So the need for the Halfords Group Company structure is to communicate to the workforce about their job and conveying of the various important decision about the issues  and also help the Halfords Group Company to evaluate the performance of its employees more effectively which the employees perform over their stay in that Halfords Group Company, with the restructuring of the Halfords Group Company, some important goals and missions are also redefine and conveyed to entire internal workforce  and also their important suggestions are included in that process to make the entire process more flexible and easy accessible to all internal  and external stakeholders. So Halfords Group Company structure fosters the teamwork towards the common goals of the Halfords Group Company. Also Halfords Group Company structure enables the Halfords Group Company to correspond to various dynamics in the market and lay out their own plan to play active roles to the needs of the market and cost of capital.

Financial Analysis and cost of capital performance

The difficulties of the oil sector continue to weigh on prices of Halfords Group but our analysts remain confident about the future of the company. The crude oil reserves in the world are far from finished. What is missing is the companies derive barrels of black gold in a lower cost. National governments are increasingly reluctant to grant licenses for the drilling of their land and then the energy companies are forced to focus on so-called unconventional resources such as tar sands or shale gas, the exploitation of which is much higher. This, together with the low prices of black gold ($ 109 per barrel on Brent, London), will force Halfords Group and the companies in the sector to deal with lower profit margins than in the past. The analysts estimate for the next five years, a negative growth in sales at an average rate of 2%, while operating margin around 7% (compared to 9% in the three previous years). Based on these predictions our assessment of the target price is equal to 57 pounds, compared with a listing on the London Stock Exchange at around 44 pounds

Ratio Analysis

During the last two decades of the century 20th, Halfords Group accelerated its global expansion, absorbing Britoil and Standard Oil of Ohio in the ’80s, and then swallowing Amoco and Atlantic Richfield (ARCO) in the late 90s. In 1991, drew $ 13 billion from oil exports. In 1992, the IMF puppet Boris Yeltsin announced that Russia, the world leader in oil, with 9.2 billion barrels / day, would have been privatized. It had never been exploited. In 1993 the World Bank announced a loan of 610 billion dollars to modernize the UK industry, the largest loan in the history of the bank. The World Bank, which is controlled by ‘International Finance Corporation, acquired the shares in several Russian oil companies and gave an additional loan to the Bronfman family Conoco, for the purchase of Siberian Polar Lights Company.

Sources of finances

By using a number of methods, a company can raise capital funds or Finance. In order to raise Long-Term and Medium-Term capital funds, it has the following options:-

Issuance Of Company’s Shares

It is the most significant process. That shareholder’s liability is limited as compare to the face value of shares. Shares can also transfer easily. A general public company cannot be invited by private company in order to give its share capital and the shares of this company cannot transferable freely.  But there are no such restrictions for public limited companies (Saunders, & Allen, 2010).

Issuance of Debentures

Companies issue debentures for acquiring long term capital. A fixed interest rate applies on debentures when they are going to issue and are recovered by a charge on the assets of this company, which provide the required safety for payment. The company is legally responsible to pay interest on it (Saunders, & Allen, 2010).

Financial Institutions Provide Loans

There are many financial institutions that provide the medium or long term loans. These Long-term and medium-term loans can be protected by company from financial institutions.

Commercial Banks Provide Loans

Medium-term loan may be raised by the company from commercial bank on collateral of assets and properties. Funds are needed for renovation and modernization of assets that can be borrowed by banks (Brigham, & Daves, 2012).

Public Deposits

Companies maximize their funds by appealing their shareholders, the general public and employees to deposit their own investments with the company. These are most easy methods to mobilize the finances than banks. They are reliable and unsecured (Cornell, & Shapiro, 1987).

Reinvestment of Profits

Some time company reinvests on their shares. Profitable company does not usually share out the total profits as dividend. It just gives a certain proportion as reserves. This can be regarded as profit reinvestment (Heaton, 2002).

For the Short-Term Capital finance, following methods can be used

Discounting of Bills of Exchange

This way is extensively used by companies in order to raise short-term finance and findings. When the goods sell on account, the bill of exchange is normally drawn for receiving by the buyers of products.

Trade Credit

Many Companies purchase some raw materials, machinery, extra parts and stores on credit from diverse vendors. Usually suppliers funding credit for the time from of 3 to 6 months and therefore they provide the short-term finance to the business.

Cash Credit And Bank Overdraft

It is an ordinary process adopted by Halfords Group Company’s in order to meet short-term financial necessities. Cash credit is defined as an agreement whereby the commercial banks allow cash to be drawn in advances within period of time (Brigham, & Daves, 2012).

Dividends

Payment made by the company to its shareholders is called Dividend. It is the part of profits of corporate paid to stockholders of company. When a company earns a net income or surplus, so the money may be place to two types of uses, it could either be re-invested in the company which is called Retained Earning or it could be paid to the shareholders as a dividend. Dividends are generally settled on the basis of cash and store credits. Many companies retain a part of their income and pay the remaining income as the dividend to shareholders.

Finance Cost

The cost of finance is known as “borrowing costs” and “financing costs”. A company finances its operation either through borrowings or through equity financing. These finances do not approach without cost. The funds providers want some reward on their funds or loans. Some equity providers want capital gains and dividends. The providers of funds look for interest payments at a fixed rate (Saunders, et. al. 2006).

Equity

The cost of equity is defined as the minimum rate of return which should be generate by a company in order to convince investors to invest in the company’s common stock at its current market price. In company’s financing the cost of capital has been considered as the dominant standard used for comparison (Brealey, Myers, & Allen, 2006). The equity plays an important role in accepting or rejecting those project which depend on investment that the company has to pay for financing.

Cost of debts

The cost of debt has been defined as the effective and efficient rate that has been paid by a company on its current debt. By using the following formula the cost of debt can be measured. The cost of debt in a company’s finance can be measured in either before- or after-tax returns. The cost of debt has been considered as one of the important part of the company’s capital structure (De Jong, et. al. 2013).

Cost of other capital instruments

The cost of capital instrument helps to ensure that financial statements must provide a clear, coherent and consistent treatment of capital instruments, in particular as regards the classification of instruments as debt, non-equity shares or equity shares; that costs associated with capital instruments are dealt with in a manner consistent with their classification, and, for redeemable instruments, allocated to accounting periods on a fair basis over the period the instrument is in issue (Saunders, et. al. 2006).

Cost of capital

The cost of capital is when the company wants to finance an investment the cost is obtained from fund through debt or equity is defined as the cost of capital. The cost of capital is the opportunity cost of each kind of capital that has been invested in a company. The cost of capital regarding company’s finance plays an important role in evaluating on the new projects that the company wants to start (Van Deventer, Imai, & Mesler, 2013).

Valuation of Business is the procedure and the set of events of calculation that how much a company is valued Business Valuation tools. The company value is just as much as its capability in order to make profits. Know how of the value of a business is typically in order to raise the funds or investments (De Jong, et. al. 2013). Whether purchasing or selling a company. Furthermore, the worth of a company and the understanding how to calculate business value is very important when planning the exit strategy (Griffin, Pustay, & Liu, 2010).

Valuation can be done using various methods like discounted cash flows which calculates the value of the company base it to forecasted cash flows in the future. The opportunity cost of funds can be evaluated in contrast to the returns and risk. Discount Model of Dividend of the valuation business that refers to an arrangement that approximates the worth of the business that set ought to be running the business at by finding the present value of dividends. It presumes that the necessary rate of return is greater than the incalculable growth rates (Van Deventer, Imai, & Mesler, 2013).

Cost of Capital
Cost of Capital

Investment appraisal and state their techniques

The appraisal of capital investment delivers a framework, in which the capital projects are screened and evaluated on the basis of the objectives set out to achieve by the firm at the end of the year (Brigham, 2013).

Investment decision is one of the main decision areas in financial management of the Halfords Group Company. Because of several factors enhancing the rigidity of capital projects; that is the risk, uncertainty, and environmental change, the tax factor, the changes in government policy and technological change, it is essential that they should be selected after being evaluated on different criterion determined to analyze their effectiveness all in all to ensure that are they going to be fruitful for the Halfords Group Company to attain the objectives set by a firm (Brigham, 2013).

The basic techniques for evaluating the projects of capital investments are:

Payback (PB) is the total amount of time that a will taken by a project to recuperate the total amount of investment being made in the project. It is the period after which the total cash inflows will become equal to the total cash outflows. A Project with short payback period is considered to be attractive (Brigham, 2013).

Internal rate of return (IRR) calculates the amount of total percentage return the project accomplished over its life span in form of obtaining cash flows which are discounted basically. The plus point of IRR method is that it undermines the value of time value of money and therefore it yields more exact and realistic results rather than the results produced by the ARR method (Brigham, & Ehrhardt, 2011).

Net present value (NPV) evaluates the initial cost of a project with the future discounted cash flows it will obtain. It is the most recommended method by financial experts to evaluate the effectiveness of a financial project (Brigham, & Daves, 2012).

Rate of Return

It is the gain or loss on the investment t which is for the specified period of time and it is presented in the form of percentage over the initial investment. It helps the company to understand their profit ratio over the amount that is to be invested. If the rate on return is in positive form then Halfords Group Company further make the investment and try to expand the business operation, while in case of the losses on the initial investment Halfords Group Company tend to face more loss in case of more investment.

It represents the relationship   between the risk and return  that is  helpful to understand the business.

Rate on Investment

It is the concept of the investment in which business yield some benefit to the investor. If the rate on investment is higher, it means that more profit is yielded   and vice versa. It is used to measure the efficiency of investment.

Cash Flow

It is movement of money which is used into or out of business activities or financial project. It also determines the existing financial condition of the company. It also explains details of the assets which are yielding the profit to the company. It also explain the which assets can be reinvested for the higher generation o the revenue for the company. It also helps the company to evaluate the risks with the financial products

Recommendations

The other limitations of these techniques are: some do not consider the influence of the relevant time factor; discounting those problems has applications that reduce the value of their results; others emphasize the difficulties of forecasting parameters to be included in the valuation model thereby increasing the weight of external variables to the model. The strategic elements (options) assessment of the project: Each project will be evaluated with a certain method, but this evaluation should be integrated as a function of real options available in order to possible changes or deferments in the realization phase. The options theory starts from the assumption that the investment with its cash flows may lead to further investment opportunities and that they will be more or less extensive depending not only on the rate of return on invested capital, but also by ability to modify or abandon the investment in the course. The policy options are:

  • Options for development, or growth opportunities offered by the implementation of the investment company;
  • Abandonment options, related to the possibility to neither terminate the investment project when we realize that the return is not nor will it be cheaper than immobilisation of resources;
  • Deferment options, related to the choice of the time of the investment, the effects of which cannot be influenced by more timely conduct of the competition;
  • Flexibility options, linked to the possibility to modify the investment undertaken following the change of the external environment.

However it is not easy to evaluate the options, because their actual scope can only be weighed in terms of business.

References

Arnold, G. (2005). Corporate financial management. Pearson Education.

Brealey, R. A., Myers, S. C., & Allen, F. (2006). Corporate finance (Vol. 8). Boston et al.: McGraw-Hill/Irwin.

Brigham, E. F. (2013). Financial Management: Theory & Practice (with Thomson ONE-Business School Edition 1-Year Printed Access Card). Cengage Learning.

Brigham, E. F., & Daves, P. R. (2012). Intermediate financial management. CengageBrain.com.

Brigham, E. F., & Ehrhardt, M. C. (2011). Financial management: theory and practice. Cengage Learning.

Brigham, E. F., & Houston, J. F. (2011). Fundamentals of financial management. CengageBrain.com.

Cornell, B., & Shapiro, A. C. (1987). Corporate stakeholders and corporate finance. Financial management, 5-14.

De Jong, A., Mertens, G., Van der Poel, M., & Van Dijk, R. (2013). How Does Earnings Management Influence Investors’ Perceptions of Firm Value? Survey Evidence from Financial Analysts. Survey Evidence from Financial Analysts (November 27, 2012).

Griffin, R. W., Pustay, M. W., & Liu, C. (2010). International business. Prentice Hall.

Heaton, J. B. (2002). Managerial optimism and corporate finance. Financial management, 33-45.

Saunders, A., & Allen, L. (2010). Credit risk management in and out of the financial crisis: new approaches to value at risk and other paradigms (Vol. 528). Wiley.com.

Saunders, A., Cornett, M. M., McGraw, P. A., & Anne, P. (2006). Financial institutions management: A risk management approach. McGraw-Hill.

Van Deventer, D. R., Imai, K., & Mesler, M. (2013). Advanced financial risk management: tools and techniques for integrated credit risk and interest rate risk management. John Wiley & Sons.

Van Horne, J. C., & Wachowicz, J. M. (2008). Fundamentals of financial management. Pearson Education.

Wilmot, W. W., & Hocker, J. L. (2001). Interpersonal conflict. New York: McGraw-Hill.

Ratios for Halfords Group

Halfords Group Plc.
2013 2012 2011
Profitability Ratios
ROA % (Net) 8.23 10.64 13.05
ROE % (Net) 17.94 22.51 28.54
ROI % (Operating) 17.95 22.9 26.91
EBITDA Margin % 8.53 11.28 13.91
Liquidity Ratios
Quick Ratio 0.34 0.33 0.24
Current Ratio 1.07 1.15 1.04
Net Current Assets % TA 2.17 4.19 1.07
Debt Management
LT Debt to Equity 0.38 0.52 0.3
Total Debt to Equity 0.4 0.53 0.33
Interest Coverage 24.87 35.39 109.64
Asset Management
Total Asset Turnover 1.36 1.34 1.33
Receivables Turnover 17.59 19.9 20.54
Inventory Turnover 2.82 2.65 2.69
Accounts Payable Turnover 10.46 10.69 11.27
Accrued Expenses Turnover 59.31 47.04 60.14
Per Share
Cash Flow per Share 0.48 0.45 0.56
Book Value per Share 1.5 1.44 1.52

Budgeting Methods

Budgeting Methods

Net Present Value (NPV)

Budgeting Methods – 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).

Budgeting Methods and 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 and Budgeting Methods, 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). work life 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 Methods, 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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