Question

The major capital budgeting criteria include Net Present Value, Internal Rate of Returns, Profitability Index, and Payback period.

• Explain their definition and calculations.
• Explain the pros and cons for each criterion

Answer 1

Capital budgeting is the method of analyzing and selecting long term investments which are in line with the goal of companies wealth maximization.

The capital budgeting decisions are important, vital and significant business
decisions because
1.substantial expenditure involved.  
2. long period for the project.  
3. irreversibility of decisions.
4. The complexity involved in decision making.

Some common measures or techniques used in the capital budgeting process are:

1. Internal rate of return (IRR)

IRR: It is the discount rate at which the present value of projects cash outflows (cost) is equal to the present value of projects cash inflow.

The IRR must be above the cost of capital/required rate of return of the southwest.

To accept the project. The project with the highest internal rate of return given the first priority.

Pros: It provides the hurdle rate above which to accept the project.
Cons: IRR method reinvest the intermediate cash flow at IRR rate, which is not true and hence not a better technique.

2. Net present value.
NPV = present value of cash inflow- the present value of cash outflow.

Discounted at the cost of capital/required rate of return.

The project with the highest net present value is given the first priority in the ranking.
NPV must be positive to accept the project.
Pros: provide absolute dollar Returns.
Cons: less insightful in terms of profitability and interest rates.

3. Payback period: it is the amount of time required to recover the original cost of the project.

The project with the lowest payback period is given the first priority.

Pros: It simple to calculate and understand.
Cons: does not take the time value of money into consideration.

4. Profitability index= present value of cash inflow/ present value of cash outflow.

The project with the highest profitability index is given the first period in a ranking.

Pros: It an analysis of cash flow of the entire life.
Cons: It ignores the sunk cost.