Question

A corporate organisation may incur a huge capital expenditure with the motive(s) of expanding operations and/or replacing a fixed asset. As a result of this, several appraisal techniques have been developed to help corporate organisations make the best investment decisions to increase the shareholders' wealth. However, among the various appraisal techniques the "Net Present Value (NPV) is considered as the king of capital budgeting." Critically examine this statement.

Answer 1

Capital budgeting is the most important and informative tool when it comes to take decision in budgeting. But, using NPV in the decision making is the most effective method.

Theoretically, it is true that NPV is considered as the king of capital budgeting but in practical, the person will get confuse because there are lot of other simple methods available to take the most effective decision.

Every company do lot of investments and mostly they do investment in fixed assets, they want to increase their operations so that the productivity will also get increased in future. This is also known as capital expenditures.

Various tools are available to guide the investor to take decision like payback period, net present value, internal rate of return.

In payback period, it automatically considers time value of money. But, this approach fails because it doesn't take fullytfully time factor in time value of money.

In net present value, it is calculated as present value of cash inflows - initial investment. It is used by large companies mostly to take major and effective decisions. It takes into account the time value of investors money.

In internal rate of return, it is the rate of return the firm will earn if it invest in the project and receives the cash inflow.

However, all the techniques are good to use and it is very difficult to choose one technique. But from a theoretical point of view, NPV is better technique because it tells us how a project creates wealth for shareholders. And for a company, shareholders are very important.

That's why NPV is considered as king of capital budgeting !