Question

(a) Define the three capital budgeting techniques: the Payback Period, the Net Present Value (NPV) and the Internal Rate of Return (IRR).

(b) Briefly discuss the advantages, disadvantages, and decision rule of each approach.

(c) If the net present value of a project is positive, which of the following statement is (are) true? Explain why

I. Its payback period is less than or equal to the cut-off point

II. Its payback period is more than the cut-off point

III. Its internal rate of return is less than the cost of capital

IV. Its internal rate of return is more than the required rate of return

Answer 1

a. Pay Back Period - It is the time period that a project will take to recover the initual investment made in the project. It is expressed in no of year.

Net Present Value - NPV or Net Present Value is the excess of Present Value of Cash Inflows (PVCI), over the Present Value of Cash Out flow (PVCO). i.e PVCI - PVCO. at a specified cost of capital / rate of discount.

IRR - It is the rate of return or discount rate at which the Present Value of Cash InFlows of a Project is equal to the Present Value of Cash Outflows.

	PBP	NPV	IRR
Advantages	Consider Cash Flows instead on Accounting Profits. Promotes Liquidity as rearlier PBP project ars promoted	Consider the Time Value of Money by discounting all the cash flows Includes all the cash flows during the life of the project	Didnt require the calculation of WACC or discount rate.
Disadvantages	Ignores time value of money Consider Initial Cash FLows only	To discount the cash flows, the WACC of the firm is required.	It assumes that cash flows are reinvested at a rate equal to IRR There may be mutiple IRR for a single project
Decision Rule	If PBP calculated < PBP critical, accept the project, otherwise reject	If NPV > 0, Accet the Project otherwise reject it	If IRR > WACC accept the project, else reject it.

answer c

Its internal rate of return is more than the required rate of return beacuse NPV is calculated at WACC which shows that NPV is positive only at a lower discount rate