Question

Why is the NPV considered to be the best method for capital budgeting? What does the NPV tell you?

What are the limitations of the payback period as an investment decision criterion? What are its advantages? Why do you think it is used so frequently?

When a firm finances a new investment, it often borrows part of the funds required, so the interest and principal payments this creates are incremental to the project’s acceptance. Why are these expenditures not included in the project’s cash flow computation?

What are sunk costs, and how should they be considered when evaluating an investment’s cash flows?

How should flotation costs be incorporated into the firm’s analysis of net present value?

Answer 1

1. Why is the NPV considered to be the best method for capital budgeting

Net Present Value is a Capital Budgeting Method considered as best method for capital budgeting because it's he most useful method to Know whether to invest in a new capital project.

I can conclude that if you are evaluating two or more totally unrelated projects so better go for NPV method for selecting the best investment plan due to better measure to know profitability of an organisation.

2. What does the NPV tell you

Net present value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. in this we compute present value of cash we generate and cash we require to pay off for a particular option or for a particular plan. and if we are getting a positive present cash value (means inflows of a particular option for a particular period of time ) than it is suggested to go for that plan.

3. What are the limitations of the payback period as an investment decision criterion

The payback period means time taken to recover the investment cost or time taken to cover cost of investment under a particular plan.

Limitation of using payback period as an investment decision criterion

first is that it fails to take the effect of time value of money , as it is very very clear that value of money goes up and down over a period of time and it is important to take effect of flucation in value of money due to time for any investment decision . it might be possible value of cash today will be worth more than in the future because of the present day's earning potential.

and other limitation is the payback analysis fails to consider inflows of cash that occur beyond the payback period, hence fails to compute the overall profitability .

4. Advantages of doing payback period analysis

1. it focused on how quickly money can be returned from an investment.

2. it is simple to understand and helpful in determine in how much time we will get our cost of investment recovered.

3. This method is helpful for smaller firms that need the liquidity provided by a capital investment with a short payback period.

4. The payback method is very useful in the industries that are uncertain, or we can say this method is useful in case of uncertainity. hence  this analysis reduce the chances of a loss.

5. Why do you think it is used so frequently?

As payback period is easy to calculate and This helps the managers to make quick decisions, something that is very important for companies with limited resources. so it need to be use again and again to get quick decision about investment options.

Hope above points helped u to get a clearity about NPV and Payback period analysis. Let us know if any other query about it.

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