Question

1.What are key approaches to capital budgeting ? What are the pros and cons of each? What is the “best” one and why? Given that there is one “best” technique for capital budgeting, what are some reasons firms have stated for not employing it? (10 points)

Answer 1

KEY APPROACHES TO CAPITAL BUDGETING-

There can be 5 main approaches to Capital budgeting as mentioned below-

1)Internal Rate of Return

2) Net Present Value

3) Profitability index

4) Pyback Period

5) Accounting Rate of return.

PROS AND CONS OF APPROACHES TO CAPITAL BUDGETING-

Approach	Pros	Cons
Internal rate of return	Capital budgeting calculations using IRR are simpliest and easiest to perform.	It sometimes overestimates the value of reinvesting cash flows and can yield abnormally high yield rates.
Net Present Value	This approach helps a company in determining the net benefit that company is going to obtain from a particular investment as adjusted with discount rate.	Calculation of Discount rate is dependent on various variables like cost of equity, cost of debt etc which is difficult to measure with certainity.
Profitability Index	It takes into consideration the Time value of money as well as the risks involved in a project.	It ignores the sunk cost.
Payback period	helps in determining the time period upto which the investment will be recovered. Projects with higher payback period can be rejected.	It ignores Time value of Money
Accounting rate of return	it is most simplified in actual numbers. Determination of an investment's accounting rate of return can be obtained by dividing the expected average profit after investment taxes by the average investment.	As seen in payback period method, the time value of the money is not taken into account.

BEST APPROACH TO CAPITAL BUDGETING-

NPV or Net Present Value is considered to be the best approach to capital budgeting. It is the most used method employed by the companys. The reason of its popularity is that it considers Time Value of Money. It determines the total cah inflows over the prject's life as discounted by appropriate discount rate and adjust it against the cash outflow, thus, giving us the net discounted benefit.

REASONS FOR NOT EMPLOYING NPV METHOD BY COMPANIES

a) It estimates the cost of capital of the company. This assumption if not made correctly may lead to increase or decrease in the Net present value and may lead to wrong decision making.

b) NPV is not appropriate method if two projects of different sizes are needs to be compared.

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