Discussion

Capital budgeting can be defined as a process of investment or an expenditure made in any investment project that can be used formally by the business. Generally, such type of expenditure or investment involve investment of huge amount of money. The main purpose of writing this report is to make an evaluation of investment done by Scottie ltd through the process of capital budgeting (WallStreetMojo., 2021). This paper will help the entity to make investment decision by using various methods of capital budgeting such as Net present value method and IRR method. In this paper we have also made discussion about why NPV method is considered as the best method for investment appraisal and how non discounting technique of capital budgeting are still gaining popularity. The report concludes by explaining some of the source of finance that can be used by Scottie Ltd for financing their investment along with the advantages and disadvantages of each source.

Capital budgeting aims to provide assistance to all organization in order to take an appropriate decision for their business by helping them to make proper investment of their funds into the organization. Investment is usually done in any business for acquiring any assets, dispositioning the asset, for making any modification in the assets so that it will help in developing the entity or for replacing any assets of the entity. Capital budgeting has become a very vital process for the business since huge amount of money is invested and risk involvement is also very high (Shahid & Abbas 2019).  For making capital investment evaluation of Scottie ltd we have determined the net present value of the investment. Net present value is generally defined as value of all cash flow that can be generated in future through adoption of capital investment project. The value obtained get discounted to bring the value to the present (Corporate Finance Institute, 2022). Thus, we can define NPV is the present value of all future cashflows of the investment which get compared with initial investment value (ClearTax, 2021).

After analysing the capital investment project of Scottie ltd using NPV Method of capital budgeting we found out that the net present value of the investment is showing positive figure. The result showed NPV amounting to $ 327,829.83. According to the general criteria used for making capital budgeting decision through NPV method, The investment project should be accepted if the results show a positive NPV or to disdain or reject the project when the results is negative. (Wang 2021). A positive NPV indicate that investment in project will make sense (Alexakhin & Zaytsev 2020).  However, if any firm will accept Negative NPV then it may destroy the value of the firm (Ling 2016).

Advantages of NPV Method

 NPV method is considered as the best method of capital budgeting because of number of reasons. Net present value takes into consideration discounted cash flows while conducting analysis, this makes the Net present value more precise than any other methods used for capital budgeting such as payback period or Internal rate of return. It takes into consideration both the time value of money as well as risk associated with the project (Bogataj & Bogataj 2019). This method involves several assumption and variables. This is considered as the easiest form of capital budgeting technique (Carlson, 2021).

Another method that we have used for making appraisal of Scottie ltd is Internal rate of return or IRR. The internal rate of return (IRR) is generally a discount rate that is used in capital budgeting. The IRR is the rate of return at which the net present value of the investment become zero (BASU 2020). The IRR makes the present value of all future cashflows of the investment and market value of the project equal to the current value in the market. The decision criteria used under this method tells the analyst to accept the project with higher IRR since higher would be the IRR the more desirable it is to undertake the project. The IRR method of capital budgeting provide a very simple hurdle for determining the feasibility of any investment project according to which projected should be avoided if the IRR is less than the cost of capital. This method generally assumes that cashflows are reinvested at constant rate every year. AS per our analysis the internal rate of return of Scottie Ltd is 21.80%. which is more than the required rate of return of the project.

Both the method that we have discussed above uses discounting method of capital budgeting. Despite the increasing use of discounted capital budgeting technique, non-discounting capital budgeting technique are also gaining huge importance. Non discounting method of capital budgeting are those method of capital budgeting that does not consider time value of money. Another way we can say under this method of capital budgeting all the dollar value that an entity will earn from the investment project in future is assumed to have same value as of today One of the most common non discounting method of capital budgeting include the use of payback period method. This method is an example of non-discounting method because it does not consider time value of money. According to the payback period method of capital budgeting, computation is done for determining the number of years an investment project will take to return the amount that equalizes with the initial cost of investment of the project (Averkamp 2022). These types of capital budgeting method are very simple and easy to use since very few inputs are needed though other methods also uses same inputs but discounting method capital budgeting involve more use of assumption such as cost of capital this makes the manager to form several assumptions so that correct cost of capital can be determined. Using the payback period method of capital budgeting is very helpful for the organization when they face uncertainty and rapid changing technological conditions (GoCardless, 2022). During such time of uncertainty, it often become very difficult to project the future annual cash inflows of the project. Thus, the chance of loss through obsolescence may get reduced by undertaking short payback period project.

Importance of Non-Discounting Capital Budgeting Methods

In this volatile market it is often difficult for organization to determine whether they are moving with the downturn or not, thus before making any investment decision it is essential to consider some other factors before making any investment. First and foremost, thing that every organization should consider is planning. This is considered as a very important aspect because this will not only help the entity to have perspective on investment goal but also assist them to understand how and when an entity wishes to achieve their goal. It helps in reducing the likelihood of emotions that might influence the investment decisions of the entity. In addition to this it is also essential for an organization to understand how much time they are giving for preparing their plan to achieve the financial goal of the business and how much risk an organization is ready to take to reach their financial goals. Understanding how the market is functioning currently also help entity to make appropriate decision Another important point that every organization should consider is determination of source of capital that the organization will use to finance their investment project.

An organization can use different sources of fund to finance their investment project this can be in the form of internal source of financing such as retained earnings, reserves available with the company and external sources of finance that include equity, issuance of bond, long term loans, preferred stock issuance. These are generally long-term source of finance that an organization can use for financing their investment project. (Kenn-Ndubuisi & Nweke 2019). Some of the advantages and disadvantages of the following sources of finance are discussed as follows. If an organization use internal source of financing such as retained profit, then dilution of ownership and profit is not possible. By using internal source of fund entity can retain the ownership control as well as help entity to increase their business ratings. However, the advantage of using internal source of finance is that it is not ideal for making long-term investment, it may affect the daily operation of the business (CFAJournal, 2021). On the other hand, using external sources of finance such as equity will help the entity to raise as much money as they require for investment. There is no burden on the company to repay the amount of loan back to the debtor but equity financing will result into dilution of ownership of business. It may create conflict arising situation if the if there exist a difference in vision, management styles and the way how business runs (thehartford.com 2022). If we look at the debt source of finance then it will provide entity with tax benefit on interest, it will also help entity to retain their shares but beside having advantage using debt will increase the debt burden of the entity, for obtaining loans entity me be required to keep their assets as collateral.

Factors to consider before making an investment decision

After analyzing various capital budgeting technique used for evaluating the investment decision. It is recommended to the entity to Accept the Investment project. The NPV of the project is showing a positive value which means that accepting the project will provide future benefit to the entity. On the other hand, calculation of IRR also showed a higher rate of discount that is more than the cost of capital of the entity. Thus, based on the IRR method of capital budgeting also we recommend to accept the project. For financing the investment project we have analyzed different sources of finance that an organization can use, out of the given sources it will be feasible if the entity will choose to make funding through combination of both equity and debt financing this will keep a balance on the burden of the company as well as provide tax benefit to the entity.

Conclusion

Thus, in conclusion it can be said that Capital budgeting play an important role in taking an appropriate decision for the entity. There are different methods of capital budgeting used for making investment appraisal such as NPV method, IRR method, Payback period method etc. In this report we have determined the NPV and IRR of Scottie Ltd which indicated a positive NPV of the investment project and a higher IRR thus it was recommended to the company to accept the project. In addition to this we have discussed about advantages and disadvantages of various source of fund such as finance through internal source of fund, equity, and debt. For Scottie ltd it was recommended to use combination of equity and debt fund for financing their investment project.

References 

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