Quantitative Methods to Study Investment Options

Cite this

Introduction

In a market economy, an enterprise is considered a prosperous one that receives a steady profit from its activities. This task can be realized on a stable basis through budgeting. The leading role in the coordination of market entities’ activities belongs to prices, and they determine the profitable volumes and methods of production for participants in economic relations (Candreva, 2017). Each enterprise is forced to subordinate its actions to the price mechanism, the law of supply and demand, since no one can cancel their movement.

On-Time Delivery!
Get your customized and 100% plagiarism-free paper done in as little as 3 hours
Let’s start
322 specialists online

From this position, planning should be viewed as a mechanism that replaces prices and the market in the enterprise’s internal activities and is carried out by drawing up budgets (Maas et al., 2016). An effective management system is the key to the enterprise’s stable operation and ensures the organization’s normal position in the market. Thus, an enterprise that wants to excel in the competition must continuously improve its management system.

It is generally recognized that the introduction of budgeting makes it possible to objectively assess all areas of an enterprise’s financial viability, improve financial discipline, and harmonize the interests of individual structural units and the interests of the company as a whole (Phan et al., 2017). In the theory and practice of enterprise management, various approaches are used to manage the enterprise’s budgeting process. For the practical application of a particular approach to budgeting, a detailed analysis of their content and identification of the specifics of use, advantages, and disadvantages is advisable.

The use of a typical budgeting model does not always lead to a positive result since the choice of a particular model should be determined by the enterprise’s specifics. To introduce the budgeting system into the practice of enterprises, many prerequisites are required (Schiavo-Campo, 2017). 1. The enterprise must have an appropriate methodological and methodological base for developing, controlling, and analyzing the implementation of the consolidated budget. 2. To set an account, an enterprise must have a management accounting system that registers economic activity facts necessary to ensure the drawing up, monitoring, and analyzing of the consolidated budget. 3. The budgetary process is always implemented through the appropriate organizational structure and management system existing at the enterprise.

This paper will consider ways of using quantitative methods to study investment options for the company’s capital budget. In addition, the areas of influence of cash flows in the context of ranking projects by the weighted average cost of capital of the company will be considered. The study will also present conclusions on the types of current investment projects similar to Exhibit 1 cash flow.

Classifying projects simply by inspecting the cash flows

Ranking of the projects for investment requires a detailed analysis of the multiple factors that are involved and can affect the overall performance. Overall ranking cannot be done merely on the basis of Cash flow due to the time value of money and the changing cost of capital of the different companies (Ross et al., 2012). The cash flows should be brought to the current value before starting the ranking of projects. Therefore, capital budgeting tools are normally used to estimate the financial performance of different projects (Porter & Kramer, 2019). However, given the different projects in Exhibit 1, the ranking on the basis of Cash Flows would be as follows:

Serial Number 1 2 3 4 5 6 7 8
Rank of Project 3 5 8 4 1 7 6 2
Cash Flows ($) 10,000 4,200 4,150 3,561 3,310 2,560 2,200 2,165

Criteria to Use to Rank Projects

To rank the eight projects, we tend to enlist them in a completely quantitative manner. The important concepts that were used to rank them are as follows:

Yes, we can!
Our experts can deliver a custom Quantitative Methods to Study Investment Options paper for only $13.00 $11/page
Learn More
322 specialists online
  • Net Present Value (NPV).
  • Internal Rate of Return (IRR).
  • Payback Period (PI).
  • Profitability Index (NPV).

Net Present Value gives the best ranking, and Internal Rate of Return works only in case there are multiple cash flows that give the results in an initial outlay followed by the future inlay (Silva, 2019). Any other sequence that does not support this will not provide the best results with the Internal Rate of Return method (Ross et al., 2012). Many times, the internal rate of return gives just a percentage and does not give sufficient credence to the number of cash flows.

Net Present Value

Year Project 1 (USD) Project 2
(USD)
Project 3 (USD) Project 4 (USD) Project 5
(USD)
Project 6 (USD) Project 7
(USD)
Project 8
(USD)
0 (2,000) (2,000) (2,000) (2,000) (2,000) (2,000) (2,000) (2,000)
1 300.00 1514.55 145.45 254.55 2,000 1,090.91 318.18
2 272.73 276.03 165.29 231.40 743.80 49.59
3 247.93 123.97 262.96 210.37 225.39 45.08
4 225.39 262.79 191.24 61.47 239.05
5 204.90 268.24 173.86 43.46 434.64
6 186.28 248.37 158.05 677.37
7 169.34 226.82 143.68 1,154.61
8 466.50 207.13 130.62 1,154.61
9 189.15 118.75
10 172.72 107.95
11 157.72 98.14
12 143.70 89.22
13 130.64 81.11
14 119.03 73.73
15 67.03
S PV (CF) 2073.086 1914.545 2393.92 2,228.22 2,129.702 2,000 2,165.041 2,182.984
NPV 73.086 85.455 393.92 228.22 129.702 0 165.0441 182.984
Rank 6 8 1 2 5 7 4 3

Internal Rate of Return (IRR)

Projects Project 1 Project 2
(USD)
Project 3 (USD) Project 4 (USD) Project 5
(USD)
Project 6 (USD) Project 7
(USD)
Project 8
(USD)
IRR 10.87% 6.31% 11.33% 12.33% 11.12% 10.00% 15.26% 11.41%
Rank 6 8 4 2 5 7 1 3

All the projects are acceptable. However, the 2nd Project cannot be the cost of capital, for it has a higher percentage than the percentage given by the IRR (Sorkin, 2018). Apart from this, Project 6 will be debatable as the cost of capital is equal to the internal rate of return. This would lead to a break-even project.

COC=10%

Payback Period (PP)

There are two methods to be used in the payback period, which are discounted and non-discounted cash flow (Samuels, 2019). The non-discounted cash flow does not take into account the TVM as well as the rate of return. Moreover, all the cash flows are not assessed in the discounted cash flow.

Projects Project 1 Project 2
(USD)
Project 3 (USD) Project 4 (USD) Project 5
(USD)
Project 6 (USD) Project 7
(USD)
Project 8
(USD)
Payback Year 7 2 15 6 8 1 2 7
Payback 2,310 2,000 10,000 1,977 2,240 2,200 2,100 4,150
Discounted Payback 1,606.58 1,790.58 2,393.92 1,360.10 1,493.78 2,000 1,834.71 2,182.98
Decision Reject Reject Accept Reject Reject Be indifferent Reject Accept
Rank 6 5 1 8 7 3 4 2

Profitability Index (PI)

Projects Project 1 Project 2
(USD)
Project 3 (USD) Project 4 (USD) Project 5
(USD)
Project 6 (USD) Project 7
(USD)
Project 8
(USD)
PI 1.037 0.957 1.197 1.092 1.065 1.00 1.083 1.0773
Rank 6 8 1 2 5 7 3 4

Ranking Found Using the Quantitative Method

As per this, almost all the projects could be considered except eight as it is mutually exclusive with Project Number 7. Moreover, the IRR for Projects 6 and 2 is less than 10%, so that cannot be undertaken.

Rank 1 2
Project 8 7
IRR 11.41% 15.26%
NPV 182.98 165.04

The projects that are selected for the final investment according to the quantitative technique are as under:

Rank 1 2 3 4
Projects Projects 3 Projects 4 Projects 8 Projects 5

The above table tells us that the ranking as per the simple inception of cash flow would be different than the given one. A comparison of the various quantitative methods predicts that project 3 scored 1st and project seven scored 1st only once when we used the IRR method. Moreover, project two scored the last four times using simple inspection flows, NPV, IRR, and the PI.

Cut 15% OFF your first order
We’ll deliver a custom Financial Management paper tailored to your requirements with a good discount
Use discount
322 specialists online

Types of actual investment projects with flows similar to those in Exhibit 1

Actual investment projects that have cash flow similar to those given in Exhibit 1 are as under:

Project 1 Bonds
Project 2 Equipment Depreciation
Project 3 Land or real assets investment
Project 4 Diary factory that incurred agricultural costs
Project 5 Car Loan
Project 6 Stock
Project 7 Truck Depreciation
Project 8 Construction of Projects

Conclusion

An efficiently functioning management accounting system allows obtaining objective and high-quality information about an enterprise’s activities, which is the basis for making management decisions. Budgeting, as a management tool, will enable the organization the enterprise’s sustainable operation and improve the company’s efficiency. To achieve the maximum effect from the introduction of budgeting in a company, it is required to individualize the budget model, taking into account the enterprise’s specifics.

The study of scientific literature on the implementation of budgeting systems in the enterprise led to the conclusion that a budgeting model’s choice is often described as a recommendation. The study found that projects cannot be classified based solely on cash flow data. The main criteria for ranking investment projects are highlighted: Net Present Value, Internal Rate of Return, Payback Period, Profitability Index. Using quantitative methods for studying within the framework of the development of investment budgets is revealed. In conclusion, a list of profitable projects with cash flow data similar to Table 1 is provided.

References

Candreva, P. J. (2017). National Defense Budgeting and Financial Management: Policy & Practice. IAP.

Maas, K., Schaltegger, S., & Crutzen, N. (2016). Integrating corporate sustainability assessment, management accounting, control, and reporting. Journal of Cleaner Production, 136, 237-248. Web.

Phan, T. N., Baird, K., & Su, S. (2017). The use and effectiveness of environmental management accounting. Australasian Journal of Environmental Management, 24(4), 355-374. Web.

Porter, M. E., & Kramer, M. R. (2019). Creating shared value. In Managing sustainable business (pp. 323-346). Springer.

Get a custom-written paper
For only $13.00 $11/page you can get a custom-written academic paper according to your instructions
Let us help you
322 specialists online

Ross, S., Westerfield, R., & Jaffe, J. (2012). Corporate finance. McGraw-Hill Higher Education.

Schiavo-Campo, S. (2017). Government budgeting and expenditure management: principles and international practice. Taylor & Francis.

Samuels, R. J. (2019). The business of the Japanese state: Energy markets in comparative and historical perspective. Cornell University Press.

Silva, E. (2019). The state and capital in Chile: Business elites, technocrats, and market economics. Routledge.

Sorkin, I. (2018). Ranking firms using revealed preference. The quarterly journal of economics, 133(3), 1331-1393.

Cite this paper

Select style

Reference

BusinessEssay. (2022, November 27). Quantitative Methods to Study Investment Options. Retrieved from https://business-essay.com/quantitative-methods-to-study-investment-options/

Reference

BusinessEssay. (2022, November 27). Quantitative Methods to Study Investment Options. https://business-essay.com/quantitative-methods-to-study-investment-options/

Work Cited

"Quantitative Methods to Study Investment Options." BusinessEssay, 27 Nov. 2022, business-essay.com/quantitative-methods-to-study-investment-options/.

References

BusinessEssay. (2022) 'Quantitative Methods to Study Investment Options'. 27 November.

References

BusinessEssay. 2022. "Quantitative Methods to Study Investment Options." November 27, 2022. https://business-essay.com/quantitative-methods-to-study-investment-options/.

1. BusinessEssay. "Quantitative Methods to Study Investment Options." November 27, 2022. https://business-essay.com/quantitative-methods-to-study-investment-options/.


Bibliography


BusinessEssay. "Quantitative Methods to Study Investment Options." November 27, 2022. https://business-essay.com/quantitative-methods-to-study-investment-options/.