Question

Assume you are the Director of Financial Planning and Analysis for your company. Make a recommendation to the CFO (me!) on how your company should approach capital budgeting and selection of projects for investment. Your recommendation can include discussion of any or all of the key topics studied in Chapters 10-14:

a) Preferred methodologies/tools (NPV, IRR, Payback)

b) Base Case, Scenario, & Simulation analyses

c) Real Options analysis

d) Impacts of Capital Structure and Leverage

What you choose to base your recommendation upon is less important than the articulation of the conceptual framework and the accurate application of that concept. Given this is a one-page recommendation, clearly you will not be able to incorporate all of the concepts above so pick one or two and demonstrate your comprehension of how it should be applied in financial analysis and capital budgeting. It needs to include, the recommendation, background about the recommendation, three reasons of rationale, risk analysis, and the next steps. These only need to be a few sentences each.

Answer 1

I have choosen the recommendation:
a) Preferred methodologies/tools (NPV, IRR, Payback):

Capital budgeting is the method of analyzing and selecting long term investments which are in line with the goal of companies wealth maximization.

The capital budgeting decisions are important, vital and significant business
decisions because
1.substantial expenditure involved.  
2. long period for the project.  
3. irreversibility of decisions.
4. The complexity involved in decision making.

Some common measures or techniques used in the capital budgeting process are:

1. Internal rate of return (IRR)

IRR: It is the discount rate at which the present value of projects cash outflows (cost) is equal to the present value of projects cash inflow.

The IRR must be above the cost of capital/required rate of return to accept the project.

In case of a mutually exclusive project, The project with the highest internal rate of return given the first priority.

Pros: It provides the hurdle rate above which to accept the project.

Cons: IRR method reinvest the intermediate cash flow at IRR rate, which is not true and hence not a better technique.

2. Net present value.
NPV = present value of cash inflow- the present value of cash outflow.

Discounted at the cost of capital/required rate of return.

NPV must be positive to accept the project.

In case of a mutually exclusive project, The project with the highest net present value is given the priority.

Pros: provide absolute dollar Returns.

Cons: less insightful in terms of profitability and interest rates.

3. Payback period: it is the amount of time required to recover the original cost of the project.

The project with the lowest payback period is given the first priority.

Pros: It simple to calculate and understand.
Cons: does not take the time value of money into consideration.

4. Profitability index= present value of cash inflow/ present value of cash outflow.

The project with the highest profitability index is given the first period in a ranking.

Pros: It an analysis of cash flow of the entire life.
Cons: It ignores the sunk cost.

Out of all these, the net present value is the superior method.