Capital budgeting Assignment PDF

CAPITAL BUDGETING 1
Task 4
Introduction
The decisions with respect to the investment in the capital assets like the land, building,
equipment, machinery, and other long term assets are the chief strategic financial decisions in
an entity. These are important because of two major reasons namely the high amount of
investments and the resources involved and the fact that these decisions cannot be reversed
once taken (Jones, 2013). Therefore such proposals need to be carried out with suitable
amount of considerations with regards to the time, investment, existing capability,
technology, disposal, and other such incidental factors. The management is required to carry
out a sound technical and feasibility study to finalise the proposals (Jones, 2013). The
following segment explains the techniques that aid in the same.
Various Techniques
Net Present Value (NPV): The method considers the time value of money. The method
involves the use of the discount rate to discount the future cash flows arising out of
operations of the projects. The same are compared with the initially invested amount of
capital. The positive NPV calls for the acceptance of the proposal and vice versa. The
limitation of the method is the discounted rate of return, which is subjective in terms of the
management discretion.
Internal Rate of Return (IRR): The IRR method in close conjunction with the NPV
method. The rate is referred to as the economic rate of return earned on the capital employed
at different points of time. In simple words it is the rate at which the net present values of the
cash oputflows equlas the net cash inflows. If the rate is less than the cost of capital, the
project is rejected and vice versa. The drawback of the method is that there can exist multiple
IRRs for a same project. The technique is beneficial in case of evaluaotmg the mutually
exclusive projects.
Accounting Rate of Return (ARR): The technique is focussed on the operating profits of an
entity. The rate is computed by dividing the expected net operating incomes pof an entity by
the initial investsment put in the proposal. The rate is further compared to the pre decided
cost of capital to reject or accept the proposal. The benefit of the technique is that it considers
the actual profits of an entity while evaluatimg the proposals. The drawback can be stated to
be the failure to consider the time value of money.