Capital Budgeting Tools Explained

This assignment delves into the world of capital budgeting tools used by businesses to evaluate investment opportunities. It provides a comprehensive analysis of prominent techniques such as payback period, discounted payback period, net present value (NPV), profitability index, internal rate of return (IRR), and modified IRR. The assignment outlines the advantages and disadvantages of each tool, emphasizing NPV's prominence in maximizing firm value by considering time value of money and risk. It concludes by discussing the practical application of these tools in real-world investment decisions.

Business finance

It can be admitted that every business has a goal to make most of the shareholder’s wealth,
and it can be attained by applying capital budgeting tools for analysis of likely investments.
Description of pros and cons of primary capital budgeting tools is as follows:
Payback period
Advantages
 Easy calculation
 Offers information regarding risky
investment
 Offers a basic liquidity measure
Disadvantages
 prevents cash flows ahead of the
payback period
 avoids the note value of money
 prevents jeopardy of cash flows in
near future
 no reality in decisive factor to show
if or if not an investment increased
the value of the firm
Discounted payback period
Advantages
 Assesses the note value of money
 Considers the jeopardy of cash flow
of project
Disadvantages
 No reality in decisive factor to show
if or if not an investment increased
the value of firm
 An estimate of capital cost is
required to make computation of
payback
 Prevents cash flows ahead of the
payback period
Net present value
Advantages
 Notifies if or if not an investment
Disadvantages
 An estimate of capital cost is

increased the value of firm
 Total cash flow is taken into
consideration
 The note value of money is taken
into consideration
 Considers the jeopardy of near
future cash flow
required to compute the net present
value
 It can interpret by considering
dollars (Tangedahl & Manuel,
2014).
Profitability index
Advantages
 Notifies if or if not an investment
increased the value of firm
 Total cash flow is taken into
consideration
 The note value of money is taken
into consideration
 Considers the jeopardy of near
future cash flow
 Helps in giving ranks and choosing
projects while there is capital
rationing
Disadvantages
 An estimate of capital cost is
required to compute the profitability
index
 Might not provide a compatible
decision while making comparison
of jointly selected projects
Internal rate of return
Advantages
 Notifies if or if not an investment
increased the value of firm
 Total cash flow is taken into
Disadvantages
 An estimate of capital cost is
required so as to make appropriate
decisions

consideration
 The note value of money is taken
into consideration (Jain, Singh &
Yadav, 2013).
 Considers the jeopardy of near
future cash flow (via capital cost in
ruling decision)
 Might not provide a value addition
decision while making comparison
of jointly selected projects
 Might not provide a value addition
decision while choosing projects
when capital is rational
 Unable to use this in circumstances
where project’s cash flow change is
more than once for the duration of
the project life
Modified internal rate of return
Advantages
 Notifies if or if not an investment
increased the value of firm
 Total cash flow is taken into
consideration
 The note value of money is taken
into consideration
 Considers the jeopardy of near
future cash flow (via capital cost in
ruling decision)
Disadvantages
 An estimate of capital cost is
required so as to make appropriate
decisions
 Might not provide a value addition
decision while making a comparison
of jointly selected projects (Burns &
Walker, 2015).
 Might not provide a value addition
decision while choosing projects
when capital is rational
Selection of suitable capital appraisal tool
In case if the business has the option to invest in the project having similar tenure and is
mutually exclusive then NPV will be used to make a selection of suitable investment option.
It is because; in the all the described techniques of investment evaluation net present value
have stated to be the topmost compared to the other criterion, as it results in the project which

will at the end maximize the value of the company. This can be attained by taking time value
of money into account and project risk as well (Brigham & Houston, 2016). Further
changing capital cost opportunities and offering added-value to a wealth of owner. However,
mostly financial managers make use of numerous techniques in the similar project evaluation
along with net present value as the priority method.