Question

Multiple tools can be used when determining which

capital projects move forward, such

as payback method, accounting rate of return, and net

present value. If capital resources are limited, which one

of the approaches mentioned would you use to analyze

a specific project and why? How would the cost

of capital impact your decision?

whether the identified method would be the best approach.

Answer 1

Capital Budgeting

Capital budgeting means choosing the project that add value to the company in the form of increasing profitability and enhance shareholders wealth.

It is a process relating to determination of Long term economic and financial profitability of the given projects and selecting best one for company based on following methods that are more common approaches to project selection.

1. Pay back period method

2. Internal rate of return.

3. Net present value method.

Above stated three methods are best approaches to decide which project should move forward and beneficial to the company. And determination of value of potential project.

Brief description of methods

1. Pay back period - Refers to amount of time required to recover it's cost of investment. It is a length of time an investment reaches break even point. Calculation of pay back period is useful in financial and capital budgeting.

Shorter the pay back period mean more attractive investment.

Pay back period calculated by,

Cost of Investment divided by annual Cash flow

Pay back period is typically used when company has limited amount of fund.

2. Internal Rate of Return - is the expected rate of return on project. If higher the rate of return than cost of capital, it's good project. It is an investments rate of return used to measuring profitability of potential investment.

IRR is technique of capital budgeting at which NPV of project becomes zero.

3.Net Present Value- shows how profitable a project than other other.

Net Present Value is the difference between present value of cash inflows and present value of cash outflows over the period of time. NPV used in capital budgeting and financial planning to analyze profitability of projected investment.

*Pay back period method is used when capital resources are limited.

When company have limited resources, then company might be able to focuses to undertake only one major project at a time. Pay back period is legnth of time taken to recover initial investment. Therefore the management focussing on recovery of initial investment in shorter period, so that the company make subsequent investment.

COST OF CAPITAL

Cost of capital is the financial tool to assess the projects and investments, to limit the cost. Cost of capital is the opportunity cost of investing the same amount in different investment opportunities. Cost of capital can also be defined as Return on Investment.

Cost of capital is tool to ascertain investment opportunity cost and maximize investment potentials.

Cost of Capital tool used by companies and investors to make better decisions on investment proposals. Investment opportunities evaluated by turning future cash flows in to present value.

Cost of capital is important for companies, who is wanted to expand their operations and funds availability.

Cost of capital is an accounting and financial tool used to turning future cash flows in to NPV. Decision of investment in projects taken on the basis of discounted NPV exceeds the expected cost of financing of the project. Whose net present value is grater that project should be choose to move forward, based on cost of capital.