Consider the following three-year projects A and B each with the same initial
investment of $1000. You are presented with the following measures for the projects:
Project A: NPV $400; Payback 24 months
Project B: NPV $545; Payback 26 months
Which project would you choose and why?
The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.
Thus capital budgeting has following characteristics:
The exchange of current funds for future benefits.
The funds are invested in long-term assets.
The future benefits will occur to the firm over a series of years.
Criteria of selection of Capital Budgeting project:
It should maximize the shareholders' wealth.
It should consider all cash flows to determine the true profitability of the project.
It should provide for an objective and unambiguous way of separating good projects from bad ...
This solution considers three-year projects and explains which project would be the best to choose.