Question

Most financial experts will agree that net present value is the best capital budgeting method. Explain why this is so and also explain how even NPV can be unreliable when projecting project results. Also Given the goal of maximization of firm value and shareholder wealth, we have stressed the importance of net present value (NPV). And yet, many financial decision-makers at some of the most prominent firms in the world continue to use less desirable measures such as the payback method. Discuss why you think this is the case.

Answer 1

1. There are many methods of capital budgeting analysis. The net present value method is considered the best method due to the following reasons

A. It considers the time value of money which is ignored by many other methods.

B. It understands the economies of scale and takes into account the dollar value of a project.

C. This method considers a rate of borrowing and lending closer to the market rates and hence is more practical.

2. The method however may be unreliable when projecting project results due to its sensitivity to discount rates and estimation for future cash flows. The assumptions and estimations made could turn the results net present value calculation all around. Even a small change in the discount rate can change the capital budgeting decisions.

3. Again the difficulties in estimation of the future cash flows and volatility in the environment which can change the discount rate substantially are the reasons why firms continue to use other methods such as payback. In times of economic unrest assuming a constant discount rate over a long period would be impractical and the net present value method would fail in such a scenario. The payback method gives the firms a clear indication of the time in which their investment would be recovered.