Question

1. Explain various discounted cash flow (DCF) methods in capital budgeting process!
2. Which method that are used in your company to make the investment decision? Give a real example!
3. Discuss the challenges the DCF methods (for example, NPV) usage!

Answer 1

1.DCF methods in Capital Budgeting Process:

Mostly Payback period, NPV, Profitability Index and IRR are used in order to evaluate the project proposal. We'll explain each as below:

1. NPV : Net Present Value : This is a time value of money concept oriented which is used to check the cash inflows with the actual investment and compare if the final value is positive or negative. If positive we'll accept the proposal else reject the same in case of negative. Cost of capital is configured as discount rate. Netting off the present cash inflows with the outflows is how we calculate NPV for a project.
2. Profitability Index: Calculated as Present Value cash flows divided by Initial Investment. PI more than 1.0 is accepted, less than 1.0 is rejected.
3. IRR: Another time value of money based technique which calculates a rate of interest till the cash inflows get paid fully. If WACC is less than IRR value we'd accept the project else we'd reject the same.
4. Payback Period:We'd calculate the cash flows to recover the first payment made, and count the years to arrive how much time it'd day to pay back. This can give us an idea as within how much time can we payback the first payment made.

2. A Real Example of some project in some company would look like this:

So we'd take a Project which is of 3 years flows and we'd calculate IRR function in the Excel to derive 20% returns. The expected rate of return on this project is 18% and the project is giving us 20% returns. With this we'd make a decision such as accepting the proposal.

3. Challenges of IRR Method:

This considers single discount rate, whereas discount rate keeps continuously changing. Also doesn't consider the project size, time or the other costs involved.