Question

the importance of making capital investment decisions. In 500 words or more, discuss the four criteria that are commonly used for evaluating and selecting projects. Briefly discuss the merits and limitations of each one of them.

Answer 1

Answer: Capital Investment decisions are really important as it gives an idea to the investors what kind of return they can expect by investing money. Is the project even feasible according to the required rate of return of the investors ? . It helps them to know should they invest somewhere else and get similar or more returns at less risk.

4 methods for the same:

1. Pay back method: it calculates if the project will be able to give back the amount invested in the project during its life cycle.

Merit: Simple and easy to judge based on this method. useful for small and simple investment projects

Limitation: Does not take time value of money in to consideration

2. NPV method: In the net present value method, you calculate the present value of all the future cash flows of the project at a given discount rate

Present value formula = cash flow/(1 + Discount rate) ^ (no of years)

Merits : takes time value of money in to consideration

Limitations: it takes the discount rate to be same for the whole life cycle of the project which is not the case as it may change going forward

3. IRR method: It gives how much return an investor can expect from the project

Merits: Considers time value of money. no requirement for predetermined cost of capital

Limitations: Becomes tricky in case of mutually exclusive projects to compare just on the basis of the IRR as different investments size may yield same IRR but different cash flows.

4. Accounting rate of return method: Uses average accounting annual income divided by the initial average investment. Calculated in % of return if it is greater than required rate of return then project is acceptable.

Merits: Simple and easy to calculate and understand.

Limitations: Does not take time value of money in to consideration. and can give misleading advice in case of different size projects.