Capital Budgeting - Techniques and Methods

This article discusses the different techniques and methods used in Capital Budgeting such as NPV, IRR, MIRR, Payback Period, and Discounted PBP. It explains the advantages and disadvantages of each method and how to make a decision based on them. The article also provides an example of how to choose between two mutually exclusive projects based on these methods.

RUNNING HEAD: FINANCE
Capital Budgeting

Finance 2
Qualitative questions
Question 1
Net Present Value is one of the capital budgeting technique used for evaluating an investment
proposal. It is the most common and popular method which measures the profitability of a
project (Baker & English, 2011).
Internal rate of return is that rate which makes the NPV of all cash inflows of a project equals
to the cash outflow of that project. It is also used for determining the profitability factor.
It is assumed in modified IRR that the cash flows are reinvested at firm’s cost of capital and
firm’s finance cost is used for financing the initial outlay. The cost and profitability of the
proposal is more accurately measured by this method.
Payback period is basically the amount of time taken by a project to recoup its original
investment.
Discounted payback period is a method of calculating payback year by considering the
discounted cash flows of the project (Baker & English, 2011).
Advantages Disadvantages
NPV It measures the value created by
the investment for the company.
It is not suitable for the projects
having different sizes.
IRR It includes time value of money. It does not takes into account the
actual value of benefits.
MIRR It reinvested all the cash flows
and make them more realistic.
It has a potential conflict with NPV
method.

Finance 3
Payback
period
Most common and Simple to use
method.
It does not considers the discounted
value of cash flows.
Discounted
PBP
It provides some idea about the
risk related to liquidity and
uncertainty
It does not considers cash flows after
break even.
Independent
When investment can be done in two projects at a time and they are not related to each other,
then it is called independent. Considering this, both the franchises can be accepted as both
have positive NPV, IRR is more than the discounting rate and payback period of the projects
is also shorter than their lives.
Mutually exclusive
When company can choose for only one project out of two and they are related to each other,
then it is called mutually exclusive projects. Among the two franchises, it will be better to opt
for franchise 1. Reason being, it has high NPV of $97.74, high IRR and MIRR of 59% and
28% respectively. Also its payback and discounted payback period is 1 year which is way
shorter than the PBP of Franchise 2. So, Franchise 1 should be accepted.
Question 2
If the projects are mutually exclusive then a proposal having high NPV, IRR and shorter
payback period is considered to be more desirable. As per the models used and calculations
done, Franchise 1 should be accepted because its NPV and IRR both are more than that of
franchise 2. Also it has shorter payback period and will prove to be more profitable.
Question 3

Finance 4
For decision making purpose, the most preferred method is NPV because it uses discounted
cash flows to cope up with the uncertainty for the future cash flows. It also measures the
profitability of a project and as per its rule, the proposal having negative NPV is rejected
whereas the one with positive NPV is accepted. Also the most desirable project will be the
one which has higher NPV (Bierman & Smidt, 2012).

Finance 5
References
Baker, H. K., & English, P. (2011). Capital budgeting valuation: Financial analysis for
today's investment projects (Vol. 13). New Jersey: John Wiley & Sons.
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of
investment projects. 9th ed. New York: Routledge.