Internet Explore the Capital Budgeting

¶ … internet explore the capital budgeting techniques used in the lesson: NP, PI, IRR and Payback. Compare and contrast each of the techniques with an emphasis on comparative strengths and weaknesses. Be sure to show you understand how each s applied and used in capital budgeting decisions.

In order to determine whether a project will prove to be profitable, a firm will likely use one of the following four methods to do so. The methods are:

Net present value ( NPV )

Internal rate of return ( IRR )

Profitability index ( PI )

Payback period ( PB )

Net Present Value (NPV):

The NPV is the entire present value (PV) of the stream of future cash funds from a project minus the project's net investment.

(Algorithm: NPV = PV of future cash flows -- Investment)

NPV Decision Rule:

If NPV ? 0 then accept

For Mutually exclusive investments, select the project with the largest NPV (FIN 301)

Procedure:

NPV is the present value of all cash flows generated by a project.

1) Find the PV of each cash flow (both inflows and outflows)

2) Add up all the PV's to get NPV.

3) Accept the project if NPV > 0. If two projects are mutually exclusive, pick the one with the higher positive NPV.

Advantages and Disadvantages of the NPV Method:

It considers both magnitude and timing of the cash flows and investigates whether a proposed project will yield the investor's required rate of return. It is also more attractive to the shareholder in that added NPV reflects higher stock prices.

On the other hand, people find it easier to work with a percentage return rather than a dollar return - which is what NPV works with.

Internal Rate of Return IRR

The IRR is the project's expected rate of return. It has to exceed NPV and the cost of capital for the shareowner to make a profit from the project.

IRR Decision Rule:

If IRR ? discount rate than accept.

For Mutually exclusive investments, select the project with the largest IRR (FIN 301)

Advantages and Disadvantages of IRR

People feel comfortable with IRR aside from which IRR reflects the timing and magnitude of cash flows.

The disadvantages however include the fact that there are usually multiple flows of IRR with unconventional cash flows. The IRR too does not distinguish between the positive investing or negative borrowing+ investing situation, whilst the NPV makes a clear distinction.

NPV is superior to IRR for mutually exclusive investments. Finally, NPV and IRR make different assumptions when it comes to reinvestment assumptions. This can result in conflicts and crossover in ranking of mutually exclusive projects.

Profitability Index (PI)

The PI calculates the present value of a project compared to its cost. It is the sum of the present values of the project divided by the initial cost of the investment.

(Algorithm: PI = NPV / Investment)

Profitability Index Decision Rule

When faced with mutually exclusive investments with capital rationing (i.e. A limit on the amount of funds available for investment), choose the project with the highest PI. (FIN 301)

PI is only used in connection with capital rationing.

Payback Period

This is the number of years that it takes for the total cash net flows of a project to accumulate to the cost of the initial cash outlay. or, in the other words, the length of time that it takes to recover the initial cost of the investment.

(Algorithm: Cost of Project

Annual Cash Inflows)

For budgetary reasons, it is often best to choose the project that has the shortest Payback Period, but if both projects are independent one can choose both.

Advantages and Disadvantages of PB:

Payback serves as useful measure for assessing the profitability of one project compared to another. It also serves as helpful measure of risk and liquidity of projects.