Answer

Required: Compare the results of the three (3) methods by quality of information for
decision making. Using what you have learned about the three (3) methods, identify the
best project by the criteria of long term increase in value. (You do not need to do further
research.) Convey your understanding of the Time Value of Money principles used or
not used in the three (3) methods
Capital Budgeting is a process of long range planning involving investment of funds in long
term activities whose benefits are expected over series of years. For example, installing
machinery, creating additional capacity to manufacture a part of the machinery which at
present is purchased from outside.

Comparisons between different types of capital budgeting techniques are as follows:Sl.NO

1.

NET

INTERNAL

PRESENT

RATE OF

PAYABACK PERIOD

VALUE
RETURN
The net present The
Internal A projects payback period reflects the
value (NPV) is rate of return is the number of periods that a project
the

present (IRR) is the rate will take

value of

of return that In order to recover its initial cash

The future cash makes

the outlay.

flows after tax present value of

less

initial the future after -

investment

tax cash flows

outlay.

equal

The

to

NPV Investment

depicts
change

the outlay.
in It is one of the

owners wealth most commonly

if

project

accepted.

is used technique
in

capital

budgeting .The
technique
also

used

is
by

security analyst.

2.

3.

Investment rule

Investment rule

Investment rule according to this

according to

according to

technique is :

this technique is

this technique is Accept the project if its life is shorter

:- : Invest if

:-: Invest

than or equal to the cut-off period

NPV>0 and

If IRR>Cost of

Do not invest if

Capital

In case of mutually exclusive projects,

NPV<0

the project with the shortest life is to

The NPV rule

The IRR

be accepted.
The payback period technique ignores

takes into

method

the time value of money

consideration

considers the

the time value

time value of

of money in

money

terms of timing
of the
Expected future
4.

cash flows.
The
major The

major The

major

disadvantage of disadvantage of disadvantage

of

this technique is this technique is this technique is as

as follows:
The

as follows:-

options The

follows :-

technique

which can be assumes that

exercised during assumes
the useful life of cash

Early cash flows

are

taken

into

that account and timing

inflows of cash flows is not

the project are can

be considered.

generally

reinvested

at The method also

ignored.

the

Therefore

it IRR.

ignores

the

risk

factors as projects

fails to take into

with different risk

account

may

significant

payback period but

flexibility

practically it is not

options

which

have

same

viable.

can be exercised

The rule is not free

during the life

from bias in case of

of the project.

long term projects

Some of the strengths of each technique are highlighted as follows:NPV technique:1. Recognises the risk associated with cash flows that are expected to generate in future
2. Considers time value of money
IRR technique:1. Single discount rate is used so less complexity involved.
2. Quantified measure of return
3. Considers time value of money
Payback period:1. Useful for understanding that when initial investment may be recouped
2. Simple method with clear idea
Profitability index:1. Considers cash flows for entire life of the project
2. Helps to take decisions on the basis of profitability for the firm.
3. Considers time value of money

Summary of the Three (3) Methods:

Therefore on the basis of the calculations given it can be concluded that
1) Gas Station B should be selected, as the investment is returned in 1 period rather than
2 periods required for Gas Station A.
2) Under the NPV criteria, however, the decision favors gas station A, as it has the
higher net present value. NPV is a measure of the value of the investment.
3) The IRR method favors Gas Station A. as it has a higher return, exceeding the cost of
funds (10%) by the highest return

.References:1. [ONLINE]

Available

at:

http://wps.aw.com/wps/media/objects/222/227412/ebook/ch09/chapter09.pdf.
[Last Accessed 11.07.2014].
2. [ONLINE]

Available

http://isites.harvard.edu/fs/docs/icb.topic725038.files/Corporate
%20Finance/CFA_Capital_Budgeting.pdf. [Last Accessed 13.07.2014].

at: