10-1

Company finance managers should also consider not investing in a single approach. They might consider
investing in portfolios in which a deficiency in one investment's gain should be balanced by a gain in
another security.

Capital budgeting may help financial managers choose investment projects in a variety of ways.

 First, it aids in assessing the Net Present Values of investment projects, i.e. establishing if net
present inflows exceed net present outflows.
 Second, it aids in computing the Net payback period, which can be beneficial in assessing the
time required to return the initial investment.
 Third, it aids in assessing the cost-return linkages between finance sources and investment
project returns. If the return exceeds the cost of funding the initiatives, the projects will be
acceptable.

10-2

The payback period is the amount of time required for the cash inflows generated by a certain project to
compensate for the initial expenditure. It is determined as follows:

10-3

The Payback period is limited by the fact that it does not account for the time worth of money. Because
the original investment is made today and the cash flows are collected at some point in the future, the
payback duration does not accurately reflect the real recovery period because the value of money has
changed.

10-4

A conventional cash flow pattern for a project entails an initial cash outlay followed by a succession of
cash inflows produced throughout the course of the project.
10-5

The acceptance criteria for NPV are:

 If NPV is positive the financial manager will accept the project

 If NPV is negative, reject the project

The Net Present Value value aids in calculating the firm's market value.

10-6

There are several similarities’ among NPV, PI, and EV A.

 All three methods discount the future cash flows to finalize the decision to accept or reject the
investment project.
 All of the strategies are widely utilized by businesses to make investment project decisions.

However, there are some distinctions between the approaches. The ease with which the approaches
can be applied varies greatly. NPV and PI are easy to use and calculate, but EV A is quite complex to
use. We want finance specialists with strong conceptual understanding to compute the EV A,
however, a person with a basic understanding of finance can calculate the NPV and PI.

10-7

The internal rate of return (IRR) assists in finding a rate at which the net present value of the project's
cash flows equals zero.

IRR is frequently utilized across the world to conclude project acceptance or rejection decisions.

After calculating the IRR, it is compared against the cost of capital. If the IRR is greater than the cost of
capital, the finance management will accept the project; otherwise, the project will be refused.

IRR is also used to rank the various investment opportunities available to investors. If the IRR of one
project is greater than the IRR of another, the former will be prioritized over the latter.

10-8
The internal rate of return (IRR) is the projected yearly rate of growth from an investment. IRR is
calculated in the same way as net present value (NPV), except that it sets NPV to zero.

10-9

If a project's IRR exceeds the firm's cost of capital, it should be approved; otherwise, it should be
refused. If the project has an adequate IRR, the firm's worth should rise.

10-10

If we have to make an accept-reject or ranking choice, NPV and IRR will provide the same outcome.

10-11

 Intermediate cash inflows - In the NPV technique, (inflows created over the project's life) are
assumed to be reinvested at the cost of capital, whereas the IRR approach implies they will be
reinvested at the IRR.
 Timing of the cash flow - The timing of the project's cash flows is immaterial when utilizing the
IRR technique, but the NPV approach favors projects with earlier cash flows when the cost of
capital is high and those with later cash flows when the cost of capital is low.
 Magnitude of initial investment - - Depending on the size of the original investment, the IRR
technique may lead to incorrect conclusions about the project's profitability.

10-12

The reinvestment rate assumption is the rate at which intermediate cash flows can potentially be
reinvested using the NPV or IRR procedures. The NPV technique implies that intermediate cash flows are
reinvested at the discount rate, whereas the IRR method assumes that the IRR is used.

10-13

When it comes to intermediate cash inflows, the NPV technique is the best option. This is because this
method implies that inflows would be reinvested at a rate equal to the cost of capital. The cost of capital
is the average rate of return demanded by investors for their investment in the firm.

In practice, the IRR method is the predominant strategy. This is because this technique is readily
comparative with other significant aspects of the organization, such as different profitability ratios and
other percentage-based indicators.