Question

   1.   You have been asked to make a short presentation at your company’s annual capital budget meeting to present an analysis of the strengths and weaknesses of the following capital budgeting selection methodologies:  NPV, payback, IRR.  Describe how you would respond to this request at the meeting.

2.  The senior executives were impressed with your presentation on capital budgeting methodologies. They have asked you to present a follow-up discussion regarding the company’s weighted average cost of capital (WACC).  Specifically, they want to know how it is calculated and, most importantly, how it should be used.  Discuss your responses.

Answer 1

Strengths and weaknesses of Capital budgeting methods ( NPV, Payback, IRR) :

NPV

Strengths-

• Time value of money is considered
• Complete cashflows are considered
• Uses the discounted cashflows

Weaknesses-

• Difficult to calculate
• The implementation of this methods needs exact estimates of the future cash flows and discounting rate.

?Payback

Strengths-

• Easy for calculation
• Provides the estimates of time to fetch back the investments
• Length of the project can also tell the risk involved in the project.

Weaknesses-

• It does not consider the time value of money
• It limits its concentration uptill the payback period and fails to approach the complete profitability of the project.

IRR

Strengths-

• uses time value of money
• It can be easily compared to the costof capital

Weaknesses-

• The process of calculations is tedious
• Creates a situation where two diff projects with diff. cashflows are compared
• It considers that the returns are reinvested on the same discount rate which is impossible to do on year on year basis.

2. WACC

Calculations:

• The total capital of the organisation from all sources is calculated
• The proportion of each capital is calculated as a part of the total capital
• The proportion should be multiplied with the cost of capital
• The above cost of capital should be aggregated .

Usage:

• Used for valuing and selecting investments
• WACC helps in acting as a discounting rate for the calculation of present value of the future cash flows.
• It is usefull in ROI calculation by considering it as a hurdle rate.