Comparing capital budgeting techniques
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Explain the capital budgeting techniques of NP, PI, IRR, and Payback. Describe the pros and cons of each, and how they are utilized to make capital budgeting decisions.
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Solution Summary
This solution compares and contrasts various capital budgeting techniques, looking at the strengths and weaknesses of each and their various applications.
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Net present value:
Meaning:
Net present value is the difference between the present value of cash inflows and the present value of cash outflows. Net present value is used as a capital budgeting technique with regards to acceptance or rejection of the purchase of plant or machinery or equipment, expansion of industrial undertaking by adding extra facilities, etc.
Criterion for decision making:
If the net present value is positive, the project will be accepted. If the net present value is negative, the project will be rejected.
In computing net present value, the future cash inflows and outflows are discounted at the cost of capital. Then the total of the present value of cash inflows from the project is computed. From that resultant figure, the present value of cash outflows like purchase price of machinery, installation charges and the increase in working capital requirements are subtracted to find out the net present value. Furthermore, if the businessman has more than one project, then he will select the project which has the highest net present value, because higher net present value increases the wealth of the shareholders.
Advantages:
1. The main advantage of the NPV method is that the time value of money is being considered. That is, the dollar of today has more value than the dollar to be received in the future. This will help in ascertaining ...
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