Question

As a student you learn about different capital budgeting techniques.Discuss these techniques and if you are an investor justify what capital budgeting technique you preferred and why? provide logical argument with support of your answer?As a student you learn about different capital budgeting techniques.Discuss these techniques and if you are an investor justify what capital budgeting technique you preferred and why? provide logical argument with support of your answer?

Answer 1

Various Capital budgeting techniques are used to evaluate a project and to take an informed decision whether to invest in the project are not. Below are the few important techniques:

NPV:

NPV, which is Net Present Value is used to evaluate a project, if the present value future expected cashflows are greater than the Initial Investment

NPV for a time period of n can be calculated using the formula: -C+C1/(1+r)+C2/(1+r)^2+....Cn/(1+r)^n; where C is the initial investment, C1 to Cn are cash inflows and r is the required rate of return.

If NPV>0, we accept a project and reject otherwise.

IRR:

IRR, which is Internal ratr of return is used to evaluate a project, if the rate of return obtained from the project is greater than the required rate of return.

IRR is the discount rate at which NPV is 0.
Let IRR be r, then -C+C1/(1+r)+C2/(1+r)^2+....Cn/(1+r)^n= 0; where C is initial investment, C1 to Cn are annual cashflows and r is IRR.

If IRR> required return, we accept the project and reject otherwise.

Payback Period:

Payback period is the period in which the cashinflows will cover the initial investment.

If the payback period is lesser than the time period required to get back the initial investment, we accept the project and reject otherwise.

Discounted Payback Period:

Discounted Payback period is the period in which the discounted cashinflows will cover the initial investment.

If the discounted payback period is lesser than the time period required to get back the initial investment, we accept the project and reject otherwise.

Profitability Index:

Profitability Index is calculated using the formula 1+(NPV/Initial Investment).

If Profitability Index>1, we accept the project and reject if it is less than 1.

Among all, NPV is the best capital budgeting technique, as the decision is based on the value added after considering time value of money.

IRR has its inherent flaws in assumptions. IRR assumes that positive cashflows can be reinvested at IRR, internal rate of return which is highly unrealistic. They can usually be invetsed at the cost of capital of the firm. In some project evaluations, it gives back multiple IRR values. Payback period ignores the time value of money.