Question

“Internal Rate of Return and Net Present Value are two of the most commonly used capital budgeting techniques”. In this light, answer the following questions:

a) Discuss thoroughly with examples, what is meant by “Capital budgeting”

b) Evaluate these two techniques considering their definitions, decision criteria and conflicting rankings. [10 Marks]

c) If you were a financial manager, discuss thoroughly with examples which technique would you prefer to apply in making your capital budgeting decisions?

Answer 1

a) Discuss thoroughly with examples, what is meant by “Capital budgeting”

Capital budgeting is the process of analyzing and making investment decisions in capital expenditure. Capital expenditure is the expenditure the benefit of which is expected to be realised over a period of time in future. Capital budgeting involves decision regarding capital expenditure which is expected to add profitability to the organisation. The commonly used Capital budgeting techniques are Net Present Value, Internal Rate of Return, Pay Back Period method etc

Example: A project has an initial investment of 10000. Firm's cost of capital is 10%. Cash inflows expected are 5000, 4000, 3000, 1000. Calculate NPV and suggest whether the project is to be accepted or not.

NPV = Present value of Inflows - Initial investment

Year	Inflow	Present value factor @10%	Present Value
1	5000	0.9090	4545
2	4000	0.8264	3306
3	3000	0.7513	2254
4	1000	0.6830	683
			10788

NPV = 10788 - 10000 = 788

NPV is a positive figure, hence the project can be accepted.

b) Evaluate these two techniques considering their definitions, decision criteria and conflicting rankings.

Net Present Value is the difference between present value of future cash flows and initial investment.

Decision criteria

If NPV is positive, the project can be accepted. If the NPV is negative, the project should be rejected

Internal Rate of Return is the discount rate which present value of future cash flows equals investment outlay.

Decision criteria

If IRR is greater than the required rate of return of the project, accept the project

If IRR is less than the required rate of return of the project, reject the project.

Ranking Conflicts

For independent projects, no conflicts will exist between the decision criterias of these two capital budgeting techniques. But in the case of mutually exclusive projects, two criteria will disagree. Suppose there are two projects A and B. Project A has higher NPV than B, and Project B has IRR greater than the required rate of return. In this situation, the conflicts arises. Here it is advised to take decision based on NPV rather based on IRR. Thus, Project with higher NPV is to be accepted.

c) If you were a financial manager, discuss thoroughly with examples which technique would you prefer to apply in making your capital budgeting decisions?

Net Present Value method is considered to be more practical or reliable method to take capital budgeting decisions. Because NPV is suitable for all types of projects whether independent or mutually exclusive projects.