Question

There are primary and secondary decision tools when evaluating capital expenditure projects. What are some of the considerations that a finance manager should take into account when deciding whether the firm should embark on a project and why?

Answer 1

There are primary and secondary decision making tools while making a capital budgeting decisions. The primary tools include those decision making processes which are inherent part of decision making such as-

1. Discounted Payback period method - discounted payback period method focuses at how quickly a project discounted cash flows at present value equates with initial cash outlays . The lesser the period, the better it is for the company.

2. Internal rate of return- Internal rate of return is the rate of return at which the discounted cash flows of a company Equates with initial cash outflows.If the internal rate of return is higher than that of hurdle rate the project is to be accepted, if the internal rate of return is lower than that of hurdle rate,The project is to be rejected.

3. Net present value-net present value is the value of net cash flows from a project. it is calculated after subtracting the initial cash outflows from the sum of cash inflows discounted at present value. The positive net present value is an acceptability criteria for the firm.

There are other secondary tools which are to be considered for capital decision making like risk levels,term for which the investment is made, , projects which are ethical or unethical in nature.

Some of the decisions of finance manager should keep in his mind before undertaking a project are-

A. The maintenance of current performance because only such projects must be undertaken which do not deteriorate the current performance of the company.

B. Risk levels- the project risk level should be based on the company risk level. If the company is highly conservative in nature, It will be against its nature to invest into a risky project even if the cash flows are positive.

C. Duration of the project- duration of the project must be kept in mind while decision making process. If the company is having a short term approach it should not be investing into project which will yield the benefits in the long term and vice versa.