Question

Compare and contrast the four most common capital budgeting techniques: NPV, IRR, Payback, and Accounting Rate of Return. What are the strengths and weaknesses of each when used as the sole investment criterion? Why do most companies use more than one method when evaluating projects? Identify several non quantitative factors that are apt to play a decisive role in the final selection of projects for capital expenditures.

Answer 1

NPV: NPV of a project is the sum of all future cash inflows less the sum of the present values of cash outflows associated with the proposal.when NPV>0 - accept the project. NPV=0 - either accept or reject the project. NPV<0 - reject the project. Strengths: it considers the time value of money and the cash inflows. different projects can be compared on NPV basis as the cash flows are converted into their present values.  Weakness: involves forecasting cash inflows and application of discount rate. thus accuracy of NPV depends on accurate estimation of these two factors which may be quite difficult in practice.   

IRR: IRR is the rate at which the sum total of discounted cash inflows equals the discounted cash outflows. so IRR of the project is the discount rate at which NPV of the project is equal to zero. IRR>K₀ - accept the project. IRR=K₀ - either accept or reject the project. IRR<K₀ - reject the project Strengths: decisions are immediately taken by comparing IRR with firm's cost of capital and helps in the basic objective of maximizing the shareholder's wealth. Weakness: it is only an approximation and cannot be computed exactly always.

Payback Period: represents the time period required for complete recovery of the initial investment in the project. Strenghts: simple to understand. suitable for industries where the risk of technological obsolescence is very high. promotes liquidity by stressing on projects earlier cash inflows. Weakness: focuses on capital recovery than profitability. does not consider post payback cash flows. this method becomes inadequate when evaluating two projects with uneven cash inflows.

Accounting Rate of Return: it is the average annual yield on the project. Profit after taxes is used for evaluation. Strengths: simple to understand and easy to operate. income throughout the project life is considered. Weakness: ignores time value of money.takes a rough average of profits of future years.

Most companies use more than one method while evaluating projects because the time period of the project differs, the cash inflows and cash outflows of the project differs, the nature of the project differs. the companies use different methods to evaluate the projects and compare those methods to decide the best project that could be finalized, in order to earn wealth maximization and minimizing the costs.

Non Quantitative factors:    Company Culture: Capital investments can have an impact on the way the work is performed in the organization. adding automation into a small business production line, as example, can change the team dynamic on the factory floor. so the manager should understand the effects the resources could have on the company culture.      Product/Service Quality:  the quality of capital resources could directly affect the quality of goods or services. the manager should be cautious about the investment's Cost efficiency. Environmental concerns: capital investments can have huge impact on the environment. and the more financially appealing options frequently have greater impacts than costlier options.     Ethical considerations: employee safety, local employment and local air quality can all be affected by investments in new facilities and equipment, regardless of the financial benefits.   

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