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Strengths and Weaknesses of Capital Budgeting Techniques

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Explain the capital budgeting techniques; NPV (net present value), PI; (profitability index), IRR (internal rate of return), and Payback. Compare and contrast each of the techniques with an emphasis on comparative strengths and weaknesses.

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The solution discusses the strengths and weaknesses and capital budgeting techniques.

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Net present value:

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 capital budgeting technique with regard to acceptance or otherwise of the purchase of equipment, expansion of industrial undertaking etc., 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 are discounted at the cost of capital. Then, total present value of all cash inflows from the project is computed. From that total, 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 business man has more than one project, then he will select the project which has higher net present value. Because higher net present value increases the wealth of the shareholders.

Advantages of net present value:
1. The main advantage of NPV method is that it is taking time value of money into consideration. That is comparing dollar to dollar value ie., the dollar worth is more today compared to the dollar to be received after some period of time. Therefore, NPV method discounting the future cash flows to its ...

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