Capella University BUS-FP3062: Capital Budgeting Techniques Report

This document provides a comprehensive analysis of capital budgeting techniques, addressing key concepts such as Net Present Value (NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), payback period, and discounted payback period. The assignment explores how organizations evaluate investments and make decisions regarding projects, including the expansion of facilities and the purchase of new equipment. The analysis includes detailed explanations of each technique, its application, and its limitations, providing a solid understanding of financial decision-making processes. Furthermore, the document highlights the importance of considering the time value of money and the impact of external factors on investment returns, emphasizing the practical application of these techniques in real-world scenarios. The document also includes a comparison of IRR and MIRR, highlighting the strengths and weaknesses of each approach and their implications for accurate project evaluation. This assignment is contributed by a student to be published on the website Desklib. Desklib is a platform which provides all the necessary AI based study tools for students.

Running head: CAPITAL BUDGETING TECHNIQUE
CAPITAL BUDGETING TECHNIQUE
Name of the Student
Name of the university
Author Note:

1
CAPITAL BUDGETING TECHNIQUE
Table of Contents
Answer to Question 1......................................................................................................................2
Answer to Question 2......................................................................................................................3
Answer to Question 3......................................................................................................................3
Answer to Question 4......................................................................................................................4
Reference.........................................................................................................................................6

2
CAPITAL BUDGETING TECHNIQUE
Answer to Question 1.
An organization has to make certain decisions regarding its investment or its expansion
so that the organization can forecast the result or effectiveness of such investment (Rossi, 2015).
In such cases, the organization needs to calculate the NPV of the inflows and make a decision on
that basis. So, Net Present Value (NPV) is the variance between the present value of cash flows
received over a period of time and the present value of cash outflow. The cash outflow is the
initial investment that is made on the project, and it may include expected negative inflow to be
received in the future (Leyman & Vanhoucke, 2016). The values of the cash inflows can be
derived at present value with the help of discounting factor rate which can be derived
considering the rate that is applicable with the investment having similar risk. A positive net
present value shows that the earnings from the investment will be higher than the anticipated cost
on the investment and vice versa.
The total of all the cash flows expected to be received in future will be converted into
present value using the discounting factor, and if the NPV is equal to or more than zero project is
acceptable, while if it is adverse or less than zero, then the project should be not be accepted.
This is the simple benchmark to be used while using NPV.

3
CAPITAL BUDGETING TECHNIQUE
In the above case, the project sould be rejected, since the net present value is negative as the cash
inflows lower than the initial investment.
Answer to Question 2.
Another capital budgeting technique for determining whether to take or reject the project
is the payback period method. Payback period denotes the time taken to recover the amount of
investment through future cash inflows. There is a direct relationship between investment and
payback period, higher the payback period more attractive is the investment (Al Ani, 2015). The
problem with this capital budgeting technique is that it ignores the time value of money, as it
avoids the concept of the discounting factor i.e. impact of inflation and earnings from substitute
investment. To compensate for such a problem, the discounted payback period is used.
The acceptable benchmark while using the payback period statistic to recover the
investment is when the maximum allowable payback period is equal to zero or less than the
calculated or expected payback period. If the payback period is not more than the maximum
allowable payback period than the project should be accepted, or else it should be rejected.
Answer to Question 3.
Also known as the discounted cash flow rate of return, internal rate of return is the rate of
return from a potential investment. The fact that the rate is internal is because it excludes the
impact of external factors like inflation, healthy returns and various other financial risks. It is a
discount rate at which the present value of the investment is equivalent to the present value of the
future cash inflows. The internal rate of return (IRR) is used to measure and compare the
profitability of the potential investment (Schlegel, Frank & Britzelmaier, 2016). It is also called
“effective rate of interest”,

4
CAPITAL BUDGETING TECHNIQUE
The acceptable benchmark for IRR is equal to or more than the cost of capital. If the IRR
is superior from the cost of capital the project should be acknowledged but if the IRR is less than
the cost of capital than the project should be rejected.
Answer to Question 4.
The IRR assumes that the cash flows from the project can be reinvested at the project’s
internal rate of return, which is not an appropriate or somewhat faulty assumption. The
assumption is not realistic as it does not include external factors, and therefore IRR sometimes
overstates the project’s true return. However, the concept of MIRR assumes that the project cash
flows will be invested again at the WACC. It is the actual rate which a company pays when it
raises the money from the market for financing a project. MIRR provides a rate that is more
useful for managers who do business in the real world (De Souza & Lunkes, 2016).
In the above case, the project should be rejected since the IRR and MIRR is negative and the
potential investment is not profitable.
The Strengths of MIRR is as follows:

5
CAPITAL BUDGETING TECHNIQUE
 MIRR observes the shortcomings of the NPV and IRR method, so it provides a better and
improved method for evaluation of the project.
 A practically possible rate for reinvestment is considered.
The weakness of MIRR is as follows:
 Calculation of cost of capital and finance rate determination is required before calculating
MIRR.
 Sometimes managers hesitate to involve the above estimates in real life.

6
CAPITAL BUDGETING TECHNIQUE
Reference
Al Ani, M. K. (2015). A strategic framework to use payback period (PBP) in evaluating the
capital budgeting in energy and oil and gas sectors in Oman. International journal of
economics and financial issues, 5(2), 469-475.
De Souza, P., & Lunkes, R. J. (2016). Capital budgeting practices by large Brazilian
companies. Contaduría y Administración, 61(3), 514-534.
Leyman, P., & Vanhoucke, M. (2016). Payment models and net present value optimization for
resource-constrained project scheduling. Computers & Industrial Engineering, 91, 139-
153.
Rossi, M. (2015). The use of capital budgeting techniques: an outlook from Italy. International
Journal of Management Practice, 8(1), 43-56.
Schlegel, D., Frank, F., & Britzelmaier, B. (2016). Investment decisions and capital budgeting
practices in German manufacturing companies. International Journal of Business and
Globalisation, 16(1), 66-78.