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

There are several factors and considerations which make the capital budgeting decisions as the most important decisions of a finance manager. These decisions may have long term effects, substantial commitments, irreversible decisions and affect the capacity & strength to compete.

So, these decisions need to be taken very carefully.

Techniques used to evaluate a capital project includes:

1. Traditional method based on accounting profit:

• Accounting Rate of Return (ARR)
  • ​​​​​​​On the basis of original investment

​​​​​​​​​​​​​​​​​​​​​= Average EAT/ original investment

2. Modern methods based on cash flows:

• Without time value of money:
  • ​​​​​​​Payback period method - Payback period can be defined as the time span over which we will be able to recover the amount invested in project.
• ​​​​​​​With time value of money:
  • ​​​​​​​Discounted payback period method - It can be defined as the time span over which we will able to recover the entire amount invested in cash along with interest.
  • Net Present Value (NPV) - It is a measure of absolute profit. It can be calculated as Present value of inflows minus present value of outflows.
  • Profitability Index- It is a measure of relative profit. It can be calculated as Present Value of inflows/ Present value of outflows
  • Internal Rate of Return - The IRR of a proposal is defined as the discount rate which produces a Zero NPV. It can be calculated as:

(By interpolation method)

IRR =

The most useful criteria to evaluate a project is Net Present Value.

Each year's cash flow can be discontinued separately from the others making NPV the better method.

​​​​​​​That's why as a finance manager we also prefer NPV.

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