Question

Define the most important capital budgeting techniques. name at least two (2) capital budgeting techniques (e.g., NPV, IRR, Payback Period, etc.) that you used to arrive investment decision.

Answer 1

NPV and Profitability index are two most important capital budgeting techniques
NPV is the PV of cash flow minus the initial investment. The discount rate is WACC of the investment.If NPV>0 then project must be accepted.
NPV strengths:
1. it factors in time value of money
2. It includes risk involves in generating cash flow/.
3. It is good in evaluating project involving large investment is of large scale projects.
4. Here reinvestment rate is discount rate or WACC which is lower than IRR.
5. It helps in ranking between projects.
Weakness:
1. it is sensitive to discount rate. Faulty calculation of discount rate can distort the results.
2. Cash flow prediction is sometimes subjective leading to variance with actual NPV.

Assumptions:
1. the reinvestment rate is same as WACC and is reinvested at higher or lower rate.
2. If two projects are equally risky, their reinvestment-rate is the same


Profitability Index =PV of all cash flows/Investment
IF PI is greater than 1 project must be accepted.

Advantages:
1. It factors in time value of money.
2. It helps in choosing project when there is constraint in initial investment.
3. It accounts for the risk in the project.
Disadvantages:
1. It doesnot include sunk cost
2. It doesnot give information about the scale of the increase in value of the firm due to a project.
3. It doesnot help in choosing from projects with different lives.

Assumptions:
1. the reinvestment rate is same as WACC and is reinvested at higher or lower rate.
2. If two projects are equally risky, their reinvestment-rate is the same