SOLVED: a. Why is the capital-budgeting process so important? b. What are the basic differences between the NPV, PI, and IRR methods? c. What are the advantages and disadvantages of each method? d. What are the issues that each method has in terms of the (2024)

FAQs

Why is the capital budgeting process so important? ›

Capital budgeting is crucial because it forces business leaders to make educated guesses about whether their significant investments will generate sufficient returns. The process is also known by the term investment appraisal.

IRR and NPV have two different uses within capital budgeting. IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a discount rate. NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. By contrast, the internal rate of return (IRR) is a calculation used to estimate the profitability of potential investments.

Answer and Explanation:

Conflicts in ranking of NPV and IRR arise when the project is mutually exclusive as in independent projects decisions are always clear. It becomes difficult to choose from higher NPV and higher IRR. Even size of the project and uneven cash flows can lead to ranking conflicts.

What is one advantage of NPV as a capital budget method? It is equally accurate whether cash flows are known or estimated. It is flexible, in the sense that the discount rate can be adjusted to account for factors like risk.

NPV is an efficient tool for making decisions about new investments because it provides a dollar return amount. IRR can be less useful when making investment choices as its results don't provide information about the amount of money a project may generate.

The advantages of the net present value includes the fact that it considers the time value of money and helps the management of the company in the better decision making whereas the disadvantages of the net present value includes the fact that it does not considers the hidden cost and cannot be used by the company for ...

While NPV focuses on absolute value and considers discounted cash flows, IRR measures the rate of return and aims to equalize inflows and outflows. Both methods have advantages and disadvantages, and their application depends on the specific project characteristics and decision context.

NPV is hard to estimate accurately, does not fully account for opportunity cost, and does not give a complete picture of an investment's gain or loss.

What are the advantages and disadvantages of NPV? ›

The NPV calculation helps investors decide how much they would be willing to pay today for a stream of cash flows in the future. One disadvantage of using NPV is that it can be challenging to accurately arrive at a discount rate that represents the investment's true risk premium.

The NPV method serves as a useful tool for investment decisions as it takes into account the time value of money, serves as a profitability indicator, assists in risk evaluation using different discount rates, and provides a basis for comparing different investments.

So, NPV is much more reliable when compared to IRR and is the best approach when ranking projects that are mutually exclusive. Actually, NPV is considered the best criterion when ranking investments.

Answer and Explanation: Since the Net Present Value method gives the result in numbers, unlike the Internal Rate of Return Method that gives outcome in percentage terms. NPV method can be used if there is more than one discount rate since each year's cash flow is discounted individually.

IRR can be considered better than NPV because of its straightforward calculation method and ease of interpreting the results. Usually, when conducting financial analysis, the projects have a hurdle rate, which is the minimum return that will deem the project acceptable.

Capital budgeting is the process of determining whether a large-scale project is worth the investment and will increase a company's value. Using a formal process for capital budgeting increases the likelihood of better outcomes.

The process of capital budgeting involves the steps like Identifying the potential projects, evaluating them, selecting and implementing the projects, and finally reviewing the performance for future considerations.

Importance of Capital Structure

A firm having a sound capital structure has a higher chance of increasing the market price of the shares and securities that it possesses. It will lead to a higher valuation in the market. A good capital structure ensures that the available funds are used effectively.