Question

Capital budgeting represents one of the most important areas of Financial management. In essence, the entire future of the company is on the line. If projects are undertaken that do not yield adequate rates of return, it will have serious long-term consequences on the firm’s profitability and even on its viability.

As a financial analyst, which one of these techniques: NPV, IRR, or the Payback period, would you use to evaluate and rank competing projects? Explain why.

Answer 1

Capital budgeting is the process by which investors determine the value of a potential investment project. It is an important tool for leaders of a company when evaluating multiple opportunities for investment of the firm’s capital. However, this is not the only step in budgeting for a new asset. It would be best to talk with a financial professional when applying the concepts discussed above while budgeting for a purchase.

WIth respect to ranking competing projects in this scenario, NPV (Net Present Value) shows how profitable a project will be versus alternatives, and is arguably the most effective of the three methods. In this technique or method, the present value of all the future cash flows whether negative (expenses) or positive (revenues) are calculated using an appropriate discounting rate and added. From this sum, the initial outlay is deducted to find out the profit in present terms. If the figure is positive, the techniques show a green signal to the project and vice versa. This figure is called the net present value (NPV).

Other methods of capital budgeting i.e.IRR and payback periods are useful in other scenarios. While IRR (internal rate of return is the expected return on a project) can be compared with the cost of capital to check viability of the project, the payback period determines how long it would take a company to see enough in cash flows to recover the original investment