Question

What capital budgeting techniques might a firm use apart from NPV and describe in words how are they calculated? What are their drawbacks, and why are they still used?

Answer 1

CAPITAL BUDGETING TECHNIQUES USED BY A FIRM APART FROM NPV AND THEIR CALCULATION -

Apart from NPV, FOLLOWING Capital budgeting techniques can be used by a firm -

1)Internal Rate of Return-

Internal rate of return is that rate at which the present value of future cash inflows becomes exactly equal to cash outflow i.e. the net benefit becomes zero. IRR is the minimum rate of return which a firm must earn inorder to breakeven.

It is calculated by discounting the cash flows at different rates using hit and trial method. The rate at which PV of future cash flows becomes equal to cash outflow, that rate will be callled as IRR

2) Profitability index

Profitability index is calculated by dividing the present value of future cash flows by the initial cost of the project.

3) Pyback Period

It is the time (number of years) in which our investment will be recovered. It can be calculated by two methods-

Averaging method- Divide the annualized expected cash inflows into the expected initial cash outflow for the asset.

Subtraction method- Subtract each individual annual cash inflow from the initial cash outflow, until the payback period has been achieved.

4) Accounting Rate of return.

Accounting Rate of Return refers to the rate which is expected to be earned on investment with respect to its initial cost. It is calculated by dividing the Average annual profit (total profit over the investment period divided by number of years) by the Initial Investment amount.

DRAWBACKS-

1) Internal rate of return- It sometimes overestimates the value of reinvesting cash flows and can yield abnormally high yield rates.

It is still used because Capital budgeting calculations using IRR are simpliest and easiest to perform.

2) Profitability Index - It ignores the sunk cost.

It is still used because It takes into consideration the Time value of money as well as the risks involved in a project.

3) Payback period - It ignores Time value of Money

It is still used because it helps in determining the time period upto which the investment will be recovered. Projects with higher payback period can be rejected.

4) Accounting rate of return- It also ignores Time value of Money

It is still used because 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.

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