Question

In what types of situations would capital budgeting decisions be made solely on the basis of project's net present value (NPV)? Identify potential reasons that might drive higher NPV for a given project. Substantiate your response by providing an example to explain your thought process.

Answer 1

As we know that NPV technique is more accurate technique for project evaluation. There are some other tools of capital budgeting analysis such as pay back period, post pay back period, profitability index etc. but NPV technique is cosidered most accurate tool because NPV consider time value hence capital budgeting decision made on the basis of NPV is considered more accurate.

If NPV of a project is positive then capital budgeting decision can be made solely on NPV basis because if NPV is positive or higher then project will be profitable because it will generate higher returns in compare to initial investment. Apart from this we know that under NPV technique annual inflows are discounted on the basis of time that is why discounted NPV will be more accurate & trusted.

Thus we can say that if NPV of a project is positive or higher then we can accept a project or vice versa and such decision will be more accurate in compare to other techniques of capital budgeting.

There are several factors which leads to higher NPV;

1. Low discounting rate leads to higher NPV because lower the discounting rate then higher the discounted cash inflows. So higher discounted cash inflows will lead to higher NPV.

2. Higher cash inflows lead to higher NPV because when a project have higher cash inflows then NPV will be higher in compare to opposite conditions.

3. Lower initial investment also lead to higher NPV because NPV is calculated with the help of discounted cash inflows and initial investment. So if initial investment in low then NPV will be higher.

4. Higher returns in low time period also leads to higher NPV because in lower period of time there will be higher discounted cash inflows and ultimately it will lead to higher NPV etc.