Essay On Capital Budgeting
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The investment decisions made on capital projects have a long-term implication of cost and benefit on any given business. This fact explains the importance of investment decisions in a business. Considering the high level of complications involved, a detailed consideration of the time value of money and cash flows of the project is necessary before deciding whether to accept or reject a project. In cases related to projects that are mutually exclusive, capital investment decision plays crucial roles. Among many processes that are used for assessing the accept and reject decisions, the following fundamental four techniques have been discussed below:
Profitability Index (PI)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Pay Back period is a simple and straightforward method and is based on universality of the process. The main focus of this approach is the liquidity focus that is then used for the evaluation of alternatives to investments. The interpretation of the results is based on the length of the pay -back period. If the time is larger, it means that there are higher risks involved and vice versa. While calculating the expenditure related to capital, this method only follows a short term approach. The two types of payback periods i.e. the discounted pay-back period and non-discounted pay-back period are based on the consideration and non-consideration of the time value of money.
NPV and IRR methods are both used for determining whether to accept or reject a given project. In finance terms, the direct dollar contribution measure that applies to the shareholders is given by NPV. The percentage return on the investment given the original money put into the business is reflected by the IRR. The limitation of NPV is that it does not allow for the measurement of the project. The restriction of IRR is that it provides decision answers that are in contrast with the results from NPV.
The net present value of a project is the amount, in rupees, the investment earns after yielding the desired rate of return in each period. Net present value= Present value of net cash flow- Total Net Initial Investment. The internal rate of return is usually the rate of return that a project earns. It is defined as the discount rate that equates the aggregate present value of the net cash inflows (CFAT) with the aggregate present value of cash outflows of a project. In other words, it is that rate that gives the project NPV of zero.
Profitability index is yet another time adjusted capital budgeting technique. It is similar to NPV approach (Investopedia, 2004). The profitability index method measures the present value of returns per rupee invested while the NPV is based on the difference between the present value of future cash inflows and the present value of cash outlays.
Comparing all the present methods, the payback method seems to be the simplest one and which is inapplicable for real life projects as it does not consider the time value of money. Net present value and internal rate of return are the most reliable methods (Peterson-Drake, P. 2015). In cases of non-exclusive projects, conflicts may arise in selecting the project in which investment is more suitable. At these times, there may be conflicting results from NPV and IRR for the same projects. In such cases, the result of NPV is to be preferred. The conflicting results may be a result of timing differences as well as size differences in the projects.
Investopedia,. (2004). Profitability Index Definition | Investopedia. Retrieved 1 February 2015, from http://www.investopedia.com/terms/p/profitability.asp
Peterson-Drake, P. (2015). Advantage and Disadvantage of the different capital budgeting techniques (1st ed.).
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