Question

Compare and contrast various methods of capital budgeting. Which method do you think is the most appropriate and why? Rationalize your standing

Answer 1

Answer-

Capital budgeting refers to the long term planning and expenditure whoes returns stretch themselves over future period

Varios methods of capital budgeting-

1)Payback period

a)Payback period refers to the period in which the project will generate the necessary cash to recoup the initial investment

Formula, Payback period = Initial investment/ Annual cash flow

b)This method focuses on projects which generates cash inflows in earliar years , thereby eliminating projects bringing cash inflows in later years.

c)This method promotes liquidity by stressing on projects with earlier cash inflows. This is a very useful evaluation tool in case of liquidity crunch and high cost of capital.

2) Net present value (NPV) method

a) The net present value is the difference between present value of cash inflow and present value of costs.

Formula, NPV= Present value of cash inflow- Present value of cash outflow

b) Net present value method consider the time value of money. Unlike payback period, all cash flow are considered.

c) NPV constitutes addition to the wealth of shareholders and thus focuses on the basis objectives of financial management.

d) Since all cash flows are converted into present value, different projects can be compared on NPV basis

e) NPV of two or more projects can be added.

3) Internal Rate of Return (IRR)

a) Thus IRR is the rate of at which the sum of discounted cash inflows equals the sum of discounted cash outflows

b) IRR is the rate at which bring the sum of the future cash flows to the same level as the original investment

The IRR is calculated under two situation

1. When cash flows are uniform

2. When cash flows are not uniform

c) In IRR method all cash inflows of the project, arising at different points of time are considered.

d) Also decision are immediately taken by comparing IRR with the cost of capital.

e) It helps in achieving the basic objective of maximasation of shareholders wealth.

4) Profitability Index

a) If the present value method is used, the present value of the earnings of one project can not be compared directly with the present value of earnings of another, unless the investments are of the same size. In order to compare proposals of the different size, the flow to investment must be related. This is done by dividing the present value of earning by the amount of investment to be given a ratio i.e called the "profitability index"

b) Formula,

Profitability Index= Present value of cash inflow/ Present value of cash outflow

c) It is better project evaluation than NPV and helps in ranking projects where NPV is positive

d) It focuses on maximum return per rupee of investment and hence is useful in case of investment in divisible projects when funds are not fully available

Out of the above methods

NPV and profitability index method are the best.

Both consider time value of money.

If we have to select one project out of two mutually exclusive projects when there is no capital rationing the NPV method should be preferred.

In capital rationing situation profitability index is a better evaluation techniques.

Hence above two methods are best subject to points mentioned above.