Question

Once a business computes its cost of capital, discuss how a manager might decide whether to take on a project or not. How are capital project investments prioritized?

Answer 1

When the identification of opportunities is done and subsequently project screening is done using the time value of money concepts like NPV, IRR, Payback Period, and profitability index.

First, the future cash flows, the initial outlay and the salvage value are identified for each project. Then the discounted values are calculated to find the net present value of the project. The discounting is done by weighted average cost of capital. If we get a positive NPV then the project is brought under consideration or else rejected.

When we have multiple positive NPVs then the priority is given to the project with maximum NPV. If we have two same NPV projects then the payback period comes into the picture.

The payback period is basically the time required to get back the initial investment completely. Project with lesser payback period is better and given priority.