Question

You are a Finance Manager for a major utility company.

Respond to the following in a minimum of 175 words:

Think about some of the capital budgeting techniques you might use for some upcoming projects.

Discuss at least 2 capital budgeting techniques and how your company can benefit from the use of these tools.

Compare your approaches to other students’ responses. How were they similar or different? Why might you use the different approaches shared by your classmates?

Using the net present value rule can help you decide if a project is worth investing in or help you decide between multiple projects. Using the internal rate of return is another popular budgeting method. This rule states that you should invest in any project offering a rate of return that is higher than the opportunity cost of capital. Both of these methods discount cash flows using specific formulas that give you a black and white answer of yes you should invest, or no you shouldn't.

Answer 1

For any Project / Major CAPEX evaluations, the three most common approaches are Payback period, Internal rate of return (IRR) and Net Present Value (NPV).

The Payback period determines how long it would take a company to see enough in cash flows to recover the original investment.

The internal rate of return (IRR) calculates the percentage rate of return at which those same cash flows will result in a net present value of zero. It used to determine the attractiveness of the Project.

The Net Present Value (NPV) results in the total net cash inflows expected from a project at the present value using a discounting factor. This is used to quantify the results in value terms from the entire project, covering all the cashflows from the project.

While most of the times NPV and IRR result in the same outcome on the feasibililty of the Project, there shall be cases of conflicting opinions as well;

Incase of analysis of a single conventional project, both NPV and IRR might provide same indicator on the evaluation of the project or not. However, while comparing two projects, the NPV and IRR may provide conflicting results.

Also, incase of mutiple cash flows trends (positive, negative, positive, negative etc) during the Project period, the IRR fails to provide answer and in this case NPV shall be useful as it covers all the cashflows - either Positive or Negative.

Hence, these need to be considered as evaluation tools and the final judgement shall be taken based on various other aspects as well; A project with lower IRR, however, more longevity might be more beneficial for an entity with a project with higher IRR with shorter life span; Many factors contribute the overall evaluation.

Also, there shall be cases where there can be multiple options among the Projects to choose and the firm need to choose one among them; Also, there shall be cases where these options also might not be of equal life, equal investment value etc;

Hence, it is always appropriate to choose multiple evaluation techniques on the Projects and finally to decide on which is more feasible option