Question

If you were the financial manager of this tourism company, would you authorize for new investment? What calculations might you use to value the potential of the new investment?

What pitfalls are associated with each type of capital budgeting: net present value, internal rate of return, and payback? How does each type of capital budgeting, and associated pitfalls, influence investment decisions?

Answer 1

If i am a Financial Manager i would be responsible for the Investment decision by considering various costs and benefits associated with the project. I would apply various capital budgeting techniques before taking the final investment decisions regarding the profitability of the project

To find the potential of new investment, first we would need to consider the initial investment or cash outflow related to Investment. To know the initial investment we would consider the following cost and variables like cost of equipment, sale value of old machine, installation cost, tax credit if machine is sold on loss and Investment in Working capital

2- We would need to consider the cash inflows related to project, Various factors related to cash flows like sale of final products, sale of machine at the end of life, recovery of working capital, non cash expenditure, recovery of working capital would be considered for net operating cash flow

3- An appropriate discount rate which is fit for the risk level by considering the inflation risk, default risk and other risk

Pitfalls related to Net present value: One of the major drawback of NPV method is that it's success depends on the correctness of accuracy of cash flow related to project and accuracy of discount rate used for discounting of cash flow so if discount rate and cash flow are not accurately determined, it may lead to selection of poor alternatives which may overstate the benefits or understate the benefits resulting in poor decision making.

Pitfall related to IRR: this method of capital budgeting is based on assumption that cash flows are reinvested at a rate equal to IRR which in actual not possible. So this assumption of reinvestment of intervening cash inflow at a rate equal to IRR may distort the final decision and over state or understate the final results

Pitfalls related to payback period is that it does not consider time value of money and it does not consider the cash flows after recovery of initial investment so payback period does not focus on profitability and pay attention only on the time period to recover the initial investment. So this method does not consider profitability related to project.