Question

Discuss how a firm can add value by combining traditional capital budgeting techniques with an alternative strategy and consider sustainable capital. Your paper should synthesize at least one alternative technique into the capital budgeting process. Justify how this technique creates value in an organization.

Answer 1

DEFINITION OF CAPITAL BUDGETING-

capital budgeting refers the process of evaluating different projects that a company wants to undertake. the evaluation is done by comparing the risks and returns associated with the project. the inflows that are expected from a project are compared with the expected returns.

TRADITIONAL CAPITAL BUDGETING METHODS

There are various traditional methods such as payback period and accounting rate of return.

PAYBACK PERIOD- it is a method in which inflows of different years are measured with the outflow and it is determined in how many years the cost has been covered by the inflows.

ACCOUNTING RATE OF RETURN- in this method , the rate of return is calculated as a percentage of inflows to initial outflow.  

all the methods are important and different firms can use different methods to determine the potential of a project

All the traditional methods have certain drawbacks. there are other methods also which a company can use instead of the above mentioned methods

some of them are-

1 NET PRESENT VALUE METHOD

2 INTERNAL RATE OF RETURN

3 PROFITABILITY INDEX

LETS UNDERSTAND WHAT IS NET PRESENT VALUE METHOD

NPV METHOD-

in this method, we discount all the future cash flows to time 0, that is present, and then deduct the cost of investment from the present value of inflows. if the NPV is positive, it is said that the project should be accepted. similarly, if the NPV is negative, the project should by rejected.

formula for discounting the future cash flows is=

cash flow*PVF(r%,n)

(the value of pvf can be determined from the annuity table)

using NPV method as a capital budgeting technique helps the company in the following manners-

1 considering time value of money-

we all know that worth of 100 rs today is different from its worth 10 years later. thus, npv is the technique which considers the time value of money and therefore helps the company to decide in a fair and correct manner it discounts all the cash inflows from future years to time 0 where t can be compared with cash outflow at time 0 only.

2 making things comparable-

we cannot compare 100 rs of today and 200 rs of 2040. comparison should be made on the same grounds. thus, npv method helps the company to compare the inflows and the outflows by making them come to common grounds and thus making comparison easier.

thus, a company can combine traditional capital budgeting methods with NPV method and help in increasing the value of the company.

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