Question

8. Conclusions about capital budgeting

The decision process

Before making capital budgeting decisions, finance professionals often generate, review, analyze, select, and implement long-term investment proposals that meet firm-specific criteria and are consistent with the firm’s strategic goals.

Companies often use several methods to evaluate the project’s cash flows and each of them has its benefits and disadvantages. Based on your understanding of the capital budgeting evaluation methods, which of the following conclusions about capital budgeting are valid? Check all that apply.

The discounted payback period improves on the regular payback period by accounting for the time value of money.

For most firms, the reinvestment rate assumption in the NPV is more realistic than the assumption in the IRR.

Managers have been slow to adopt the IRR, because percentage returns are a harder concept for them to grasp.

True or False: Sophisticated firms use only the NPV method in capital budgeting decisions.

True

False

Answer 1

Yes, it is true that the regular pay back period method, ignores the concept of time value of money. The discounted pay back period, also takes into account the concept of the time value of money.

This statement is TRUE. The IRR assumes that the cash flows are reinvested at the IRR and the NPV assumes that the cash flows are reinvested at the cost of capital. The NPV is more realistic than the IRR.

This statement is not true as the percentage returns is an easy concept to grasp and understand.Since, IRR is expressed as a percentage it is preferred by some decision makes due to it's ease and simplicity.

This statement is FALSE. The sophisticated firms use multiple methods as the IRR, payback period method and the MIRR . Each method provide a different information which can be relevant to the decision makers.