Capital Budgeting Analysis: Evaluating Investment Projects Methods

This report delves into the critical aspects of capital budgeting, exploring the methods used to evaluate potential investment projects. It examines the Payback Period (PBP), Net Present Value (NPV), and Internal Rate of Return (IRR) techniques, highlighting their strengths and weaknesses. The report emphasizes the importance of considering the time value of money and the implications of different discounting rates. It provides a comparative analysis of the methods, suggesting that a combined approach using NPV and IRR can offer optimal results, while also emphasizing the need to consider external factors. The report also includes references to relevant academic sources to support the analysis and findings. Overall, the report aims to provide a comprehensive understanding of capital budgeting techniques for effective project evaluation and investment decisions, ensuring that the management considers all the factors before applying the techniques.

CAPITAL BUDGETING TECHNIQUES
Payback Period (PBP) calculates the time period by which the project is capable of recouping the
initial investment made. The method is easy to apply and provides an overall idea about the cash
richness of the project. However, PBP does not consider the time value of money (TVM) and
hence may not be suitable for complex projects with more than 3 or 5 years duration (Woodruff,
2018).
Net Present Value (NPV), on the other hand, considers the TVM in such a manner that the
management gets a fair idea about the profitability of the project. Since NPV takes into
consideration post-tax cash flow adding back depreciation, the method is suitable for evaluating
the financial worth of a project in terms of its ability to revenue profit as well as cash flow.
However, NPV is too much dependent on the discounting factor and the assumptions that the
cash flow generated gets reinvested at the same rate (Magni & Martin, 2017). Moreover, the
application of the technique is a bit complex.
Lastly, the Internal Rate of Return (IRR) may be construed to be the extension of NPV. In IRR,
the management evaluates the discounting rate at which the NV of the project becomes zero. In
other words, the IRR method puts more emphasis on the discounting factor and hence, the capital
cost of the project. However, IRR may not be suitable where the project generates uneven cash
flow year wise and change in discounting factor significantly affects the project’s cash flow
performance (Abor, 2017).
Therefore, it may be concluded that NPV is comparatively superior and a combined application
of NPV and IRR may provide optimum result in terms of project evaluation. However, the

management must consider the TVM and other externalities as well before applying NPV and
IRR.
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References:
Abor, J. Y. (2017). Evaluating Capital Investment Decisions: Capital Budgeting.
In Entrepreneurial Finance for MSMEs (pp. 293-320). Palgrave Macmillan, Cham.
Magni, C. A., & Martin, J. (2017). The Reinvestment Rate Assumption Fallacy for IRR and
NPV.
Woodruff, J. (2018). Three Primary Methods Used to Make Capital Budgeting Decisions.
Retrieved from https://smallbusiness.chron.com/three-primary-methods-used-make-
capital-budgeting-decisions-11570.html
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