Question

Which method of capital budgeting is considered the most appropriate and why ? (should be 400 words min.)

Answer 1

The Net Present Value method is perhaps the best method of capital budgeting decisions.

The net present value ( NPV ) of a project is the sum of the present values of all the cash flows ( positive and negative ) that are expected to occur over the life of the project.

NPV = C _t / ( 1 + r ) ^t - Initial Investment, where C_t is the cash flow at the end of year t, n is the life of the project, and r is the discount rate.

The net present value represents the net benefit over and above the compensation for time and risk. Hence the decision rule associated with the NPV criterion is: Accept the project if the NPV is positive, and reject it if the NPV is negative.

The net present value has certain properties that make it a very attractive decision criterion:

a. The NPV criterion takes into account the time value of money.

b. Net present values are additive.: The value of a firm can be expressed as the sum of the present value of projects in place as well as the net present value of prospective projects. Further, when the firm terminates an existing project which has a negative NPV based on its expected future cash flows, the value of the firm increases by that amount. Thirdly, when a firm divests itself of an existing project, the price at which the project is divested affects the value of the firm. If the price is greater / lesser than the present value of the anticipated cash flows of the project, the value of the firm will increase/decrease with the divestiture.

c. Intermediate cash flows are invested at the cost of capital: The NPV rule assumes that the intermediate cash flows of a project, i.e the cash flows that occur between the initiation and the termination of the project, are reinvested at a rate of return equal to the cost of capital.

d. NPV computation permits time varying discount rates: Discount rates need not be constant over time. The NPV can be computed using time-varying discount rates arising due to change in interest rates, the risk characteristics of the project and the financing mix of the project leaading to change in cost of capital.