Question

To support growth strategies and combat competition with rivals, businesses seek external capital to further develop products and services in hopes to create new sales opportunities. Since capital investment often involves a huge money investment, longer time engagement and risks of uncertainties, any decision shall not be taken lightly and shall be carefully evaluated before putting money to start a long-term project. The goal is to ultimately make the right accept/reject decision. Respond to the following in a minimum of 175 words:

• Discuss criteria and techniques used to evaluate a capital project. Which criteria and techniques do you consider the most useful? As a financial manager, would you use the same criteria or evaluation techniques for any capital project? Why or why not?  

Answer 1

The capital budgeting decisions are considered as one of the most important decisions for any organization. Following are the techniques used to evaluate a project.

CRITERIA AND TECHNIQUES USED TO EVALUATE A CAPITAL PROJECT

1. PAYBACK PERIOD

The payback period is the period within which all the initial investment would be covered through the cash flows generated by the project.

It is computed as :

Payback period = Initial Investment/ Annual cash flows

Criterion: If the payback period is less than the period set by the firm, We accept the project.

2. AVERAGE RATE OF RETURN

It is the return generated on Investment.

ARR = Average Annual net earnings/ Average Investment * 100

Criterion: If the ARR is more than the expected return, We accept the project.

3. NET PRESENT VALUE(NPV)

The NPV is the difference between the present value of cash inflows and outflows.

NPV = Summation of Present value of cash inflows - Present value of cash outflows

Criterion: If the NPV is greater than 0, We accept the project.

4. PROFITABILITY INDEX(PI)

It is the ratio of present value (pv) of cash inflows to the present value of cash outflows.

PI = PV of Cash Inflows/ PV of Cash outflows

Criterion: If the PI is greater than 1, We accept the project.

5. Internal Rate of Return(IRR)

It is that rate where the present value of cash inflows is equal to the present value of cash outflows i.e. where the NPV is 0.

Criterion: If the IRR is greater than the cut off rate set by the firm, We accept the project.

MOST USEFUL TECHNIQUES

Among the various techniques that can be applied while evaluating a project, the NPV and IRR are considered as the most useful techniques. This is because, these techniques use the Time value of money concept which helps in depicting the true value and benefits of a project.

As a Financial Manager, I would not use the same criteria for any capital project, since all these techniques have some or the other merits and drawbacks that make them suitable for some projects and unsuitable for the other. For example, though Payback Period and ARR are easy to calculate methods and involve less time and effort, they lack the consideration of time value of money. Similarly, a project may have the highest IRR among all other projects to choose from, but may not have high NPV. Therefore, as a financial manager, I would study each project and technique carefully.