Question

Capital Budgeting Techniques: An Overview of Pros and Cons

There are three types of techniques most common in capital budgeting projects. These techniques include the Payback Method, Internal Rate of Return, and Net Present Value. Compare and contrast all three of these techniques and report the challenges and benefits of using each. Then, from these three recommend the one you feel is most beneficial for companies to use in their budgeting processes and support your decision with at least three sources, please.

It's not about the essay- I wanted to understand how budgeting techniques work within 300 words. Thank you all the Savvys out there!

Answer 1

Payback period - It tell within what time period the project is able to recover the initial investment made. It emphasis on early recovery of money thereby liquidity, but the limitation is that it ignores time value of money. The criteria should be select those projects having lesse pay back period.

NPV = It is the excess of present value of cash inflow over the present value of cash inflow, i.e PVCI - PVCO. It discounts all the future cash flows with the cost of capital and calculate the surplus the project generate. however the problem here is that cost of capital should be available.

IRR It is that rate return at which the PVCI = PVCO. so it gives a upper limit. If cost of capital is less than IRR then the project should be accepted.

The concept can be understood by using the following example

Cost of Machinery	$        2,500,000
Annual Cash Flow	$           600,000
Life in year	6
Salvage Value	$           350,000
Critical Payback Period in years	5
Required Rate of Return	15%
PVAF(r,n)	3.7845
PVF(r,n)	0.4323

Pay Back Period (Cost/Annual Cash Flow)

4.166666667

Since it is less than critical PBP project should be accepted

NPV Calculation
PVCI (PV of annual CI + PV of Salvage Value)	$                2,422,004.27
Less :      PVCO (Cost of Machinery)	$                   (2,500,000)
NPV	$                   (77,995.73)
Since NPV is Negative, the Project should be Rejected

IRR

13.899%

Since IRR is less than cost of capital, project should be rejected