Question

1. 2 capital budgeting methods that use present value analysis and describe each.

2. 2 capital budgeting methods that do not use present value analysis and describe each.

Answer 1

Techniques that use present value analysis are:

1. Net Present Value Technique (NPV) - In Net Present Value Technique, its assumed that a dollar of cash flow in the early years is of a project is worth more than a dollar received in the taer period.

This method, uses a specific discounting rate on all its cash flow likely to be received in the future year)s) to its present value and then compare it with the Initial Investment. If NPV > 0, accept the project, if NPV < 0, reject and if NPV= 0, indifferent.

2. Internal Rate of Return Method (IRR) - In IRR, The other factor remains same as NPV i.e, time value of money, initial investment along with the total amont of cashflow, the only thing changes here , instead of using the desired rate of return for the purpose of discounting cash flows, but it estimates the discount rate that equates the present value of the expected net cash inflow with initial cash outflow.

Techniques that doesn't use present value analysis are:

1. Accounting Rate of Return(ARR) : It is simple method, which used the total expected average net income in the coming years from the project as a percentage of its average investment.

Average net income is the sum of all the incomes to be received divided by no. of years.

Average Investment considers the initial investment, salvage value, installation cost, any further costs that might be incurred during the tenure of project, etc.

2. Payback Period- Payback period of an investment is the length of time required for the Net Total cash inflow expected from the project to be equal to initial investment. It helps the organisation in assessing the amount of time needed for organization to recover the cash invested.

Longer the payback period, riskier the project as in long run there are many uncertainities, and therefore increases the risk.