Question

What are the different methods that can be used to evaluate capital investments? What are the strengths and weaknesses of the various methods? Which method do you believe is the best? Why?

Answer 1

A.

• Payback Period. The payback period is the most basic and simple decision tool. ...
• Net Present Value (NPV) The net present value decision tool is a more common and more effective process of evaluating a project. ...
• Internal Rate of Return (IRR)

B.

ADVANTAGES OF CAPITAL BUDGETING:

• Capital budgeting helps a company to understand various risks involved in an investment opportunity and how these risks affect the returns of the company.
• It helps the company to estimate which investment option would yield the best possible return.
• A company can choose a technique/method from various techniques of capital budgeting to estimate whether it is financially beneficial to take on a project or not.
• It helps the company to make long-term strategic investments.
• It helps to make an informed decision about an investment taking into consideration all possible options.
• It helps a company in a competitive market to choose its investments wisely.
• All the techniques/methods of capital budgeting try to increase shareholders wealth and give the company an edge in the market.
• Capital budgeting presents whether an investment would increase the company’s value or not.
• It offers adequate control over expenditure for projects.
• Also, it allows management to abstain from over investing and under-investing.

DISADVANTAGES OF CAPITAL BUDGETING:

• Capital budgeting decisions are for long-term and are majorly irreversible in nature.
• Most of the times, these techniques are based on the estimations and assumptions as the future would always remain uncertain.
• Capital budgeting still remains introspective as the risk factor and the discounting factor remains subjective to the manager’s perception.
• A wrong capital budgeting decision taken can affect the long-term durability of the company and hence it needs to be done judiciously by professionals who understands the project well.

C.

In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.

All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment.

Although using one discount rate simplifies matters, there are a number of situations that cause problems for IRR. If an analyst is evaluating two projects, both of which share a common discount rate, predictable cash flows, equal risk, and a shorter time horizon, IRR will probably work. The catch is that discount rates usually change substantially over time. For example, think about using the rate of return on a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1% and 12% in the last 20 years, so clearly the discount rate is changing.