UNIT VII PAPER

Unit VII Paper - Capital Budgeting Techniques

Demetrius Walker
Financial Management BBA 3301-12k-7

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Unit VII Paper
Capital Budgeting Techniques

Net Present Value

Net present value (NPV) is an investment appraisal technique which is used to help in
taking project choosing decisions. The prime idea on which net present value concept is based is
that of time value of money. The net worth of cash flows changes over time and due to this
profitability/gain from a project also vary accordingly. A positive NPV demonstrates that the
project is desirable. Company also accept project having 0 NPV because at 0 NPV the required
return of company is equal to the return of project (Kerzner, 2013). The strength of NPV is that it
works well for independent and mutually exclusive projects, takes all cash flows into account,
and consider concept of time value of money. However the weakness of NPV is that it gives a
dollar figure rather than a percentage figure, which people tend to at times confuse with the cost
figure.
Profitability Index
Profitability index is also known as benefit-cost ratio. It is an investment appraisal
technique which is calculated by dividing future cash flows present value by the projects initial
investment. The basic idea is that it divides projects inflow with outflow to calculate
profitability index. The main difference between Profitability Index and Net Present Value is that
it gives a ratio amount while NPV gives a dollar amount. A project is considered desirable if
profitability index is greater than 1. The strength of this measure is that it tells whether the
project increase value for the firm, takes all cash flows into account, consider concept of time
value of money, and consider future cash flow uncertainty concept. The weaknesses of this
measure are that it cannot be used for comparing the mutually exclusive projects.
Internal Rate of Return
The internal rate of return (IRR) is an investment appraisal technique which gives a
relative rate of return to compare and measure profitability of projects. Its also known as

UNIT VII PAPER

discounted cash flow rate of return (DCFROR). Internal rate of return is very effective in
decision making because it indicates the yield, quality and efficiency of a project. The point of
difference between NPV and IRR is that it indicates the magnitude and value of a project. The
point of decision is that IIR should be greater than cost of capital or minimum acceptable rate of
return (Cooper, Cornick, & Redmon, 2011). The strength of IRR is that it considers time value of
money, considers uncertainty of future cash flows, and assesses the value increment from the
project. The weakness of IRR is that it does not instigate a value maximizing decision.
Payback Period
The Payback Period is an investment appraisal technique which depicts the specific time
it takes for a project to recover its initial cost. Its one of the simplest types of investment
appraisal decision which relies on the concept of cost versus benefit analysis. It can be used for
independent and mutually exclusive projects. The strength of payback period is that its very easy
to compute, provides measure of projects liquidity, and gives the risk information. On the other
hand the relative weaknesses of using payback period to evaluate projects are that future cash
flows are ignored, time value of money is not considered and how the project effects
organizations worth is ignored.
The goal of firm from financial perspective is to maximize its bottom line. In this goal
bottom line refers to the profits earned by the company in any given time period (Lasher, 2011).
On the other hand profit maximization is considered as the prime goal of all the firms but there
can be other financial goals as well on which the company can base its business such as:

Profit Maximization

Shareholders Wealth Maximization

The different financial goals any firm can opt for depend on their view, for instance if a
company is in business for short-term only then they will focus on profit maximization. On the
other hand if a company is in business for long-term, then its focus will be on wealth
maximization.

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The stakeholder approach holds that the firms management must maximize the wealth of
its stakeholders. The total value or worth of any firm is the aggregate total all the financial
claims of firm such as warrants, preferred stock, debt or equity.
So what usually happens is that there is clash between the interest of management and the
interest of stakeholders as one wants the company to focus on profit maximization and the other
one wants company to focus on wealth maximization.
To conclude firm must keep its financial goal in line with the goal of stakeholders, which
wealth maximization is (Jensen, 2010). This decision is more rational because profit
maximization is successful only in short-term, does not focus on the timing of returns (time value
of money), and ignores the risks associated with profit maximization.

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References

Cooper, W. D., Cornick, M. F., & Redmon, A. (2011). Capital budgeting: A 1990 study of
Fortune 500 company practices. Journal of Applied Business Research (JABR), 8(3), 2023.
Kerzner, H. R. (2013). Project management: a systems approach to planning, scheduling, and
controlling. John Wiley & Sons.