Question

What do you perceive to be the main benefits and drawbacks of the key standard capital budgeting methods?

Please analyze a potential capital budgeting project from the industry in which you now work or the one of interest to you. What is the project? Describe and provide an approximate value of the initial cash flow.

Answer 1

Capital budgeting is the process of deciding whether a project is profitable or not. This is done by techniques like NPV, IRR, Payback period and Profitability Index.

Payback period: it is the calculation of the time period in which the investment of the company in a project will be earned from the cash inflow. The advantage of this method is that it is simple and easy to calculate. But it does not take time value of money into consideration.

NPV or Net Present Value is the calculation of the present value of the project after deducting the present value of cash inflows from the present value of cash outflow. This is a good method as it takes into consideration the time value of money. But it is highly sensitive to discount rates and does not take into consideration the size of the project.

IRR or Internal Rate of Return is the method of calculating the rate of return that the project should earn. This is a little complicated in calculation but it considers time value of money.

Example of a project: A battery manufacturing plant wishes to increase its production capacity which can be done by installing a new battery assembly machine. The capital budgeting decision should be taken using NPV. The estimated cash outflow is $50,000. Once the manufacturing process begins then the company will start earning cash or there will be cash inflows.