Capital Budgeting Techniques

Capital Budgeting Techniques

Introduction

Research work by Dayanada (2002) describes the methods as the approaches employed to determine worthwhile projects or investments such as building, new plan or any other venture that a corporation intends to undertake. The different methods avail information and decision criteria. Organizations utilize the techniques to make a judgement on project acceptance or rejection. The essay makes a comparison of the capital budgeting tools based on the techniques strengths and weaknesses.

Comparison of strengths and weaknesses

Corporations employ Payback method in determining the time a project will take to return the initial investment committed to the venture. Experts in the filed compute the outcome by dividing the total cost of the project with the annual expected inflow. On the other hand, Net Present Value Analysis indicates the distinction between the present value of monetary inflows and outflows to ascertain whether the result is negative or positive (Dayanada, 2002). Negative NPV leads to rejection whereas a positive value indicates that a project is worth and is therefore accepted. Relative to Payback period, NPV uses the cost of capital to calculate the present value.

An article by Dayanada (2002) asserts that NPV method undertakes an accurate quantification and provides answers to whether a firm’s values will rise or fall after investing in the venture. The payback value is computed by dividing the annual cash flow expected with the overall cost of a project. Relative to the NPV strength, Payback period lacks complexity during computation and avails to business managers understating regarding the degree of risk involved in the project. Dayanada (2002) argues that one weakness associated with NPV is the difficulty the method has in estimating the real cost of capital because the NPV value calculated may be erroneous. Contrary, the weakest point associated with Payback technique is the fact that the approach ignores the benefits earned after the payback period lapses therefore unlike the NPV, Payback approach fails to account for money time value.

The internal rate of return presents to business decision makers chance to quantify the rates in investment. Dayanada (2002) defines the tool as the discount rate of an investment occurring when the costs of a project equals revenue i.e. breaks even. Compared to other capital budgeting techniques, the method is popular from its strength in providing viable options on a project’s value. Initial calculations of the value are easy to compute thereby proving figures that the executives lacking financial background can comprehend. Relative to NPV, PI and Payback methods, IRR technique has tremendous risks that overshadow the merits. Dayanada (2002) notes that the tool is inconsistent and puts shareholders wealth at risk. Moreover, the method can produce abnormally high rates of return following an overestimation of the reinvesting cash flow value of over time.

Profitability Index also termed as cost-benefit ratio ascertains the monetary project cost by comparing the benefits with expenditures. Investment is worth only when PI exceeds 1 (Dayanada, 2002). The technique shares some similarity with NPV because both leads to identical decisions in a project evaluation. PI is easier to comprehend and communicates more efficiently relative to NPV. The tool can be applied to any project regardless of venture size. On the flipside, Dayanada (2002) observes that the figures obtained are not as accurate as the ones computed using IRR and PI.

References

Dayanada, D. (2002). Capital Budgeting: Financial appraisal of investment projects. Cambridge, UK: Cambridge University Press.

 

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