Question

In what types of situations would capital budgeting decisions be made solely on the basis of project's net present value (NPV)? Identify four or five potential reasons that might drive higher NPV for a given project. Substantiate your response by providing two examples to explain your thought process. Please keep in mind other answers to this question on the web that may be inadequate.

Answer 1

Capital budgeting decisions should be made solely upon the basis of net present value when there would be different projects with equal lives and these projects are generating uniform rate of cash flows over equal time duration so they will be compared and decision will be made according to the net present value because net present value will be comparing the net cash inflows and net cash outflows in order to arrive at net present value by discounting those cash flows.

Net present value will be discounting the net cash flows at the present of different products which will be having equal life so it will only be applicable in case of projects which are having equal life in comparing independent project or mutually exclusive project.

In such cases,when the project will be having unequal lives then equivalent annual annuity, should be used instead of net present value method

Reasons which will be driving net present value higher would be as follows-

A. Higher amount of cash inflows-when there would be higher amount of cash inflows, then there would be higher probability of positive net present value

B. Lower amount of discounting rate-lower amount of discounting rate would be resulting into higher amount of net present value because there would be discounting with lower rate

C. Higher growth rate of the company.-when they would be a higher growth rate of company would mean that the company has the capacity of increasing its cash flows and it would mean that it will be increasing the net present value of the project.

D. Lower cash outflows of the company- lower cash outflows will be reflecting the cost cutting ability of the company and it will be reflecting the net present value on the positive side.