Q5Managerial Economics & Financial Accounting
Question
Critically examine the various methods of evaluation of capital budgeting proposals.
Answer
Traditional methods like Payback are simple but ignore the time value of money. DCF methods like NPV and IRR are scientifically superior but complex.
Capital budgeting proposals evaluate multi-year investment projects. The methods are evaluated based on whether they account for cash flows, the whole life of the project, and the Time Value of Money (TVM).
- Concept: Measures the time taken to recover the initial investment. - Pros: Very simple to understand and calculate. Highly useful for risk-averse firms prioritizing short-term liquidity and avoiding technological obsolescence. - Critique: It completely ignores the time value of money (a dollar earned in year 1 is treated the same as year 3). Fatally, it ignores all cash flows that occur after the payback period, potentially rejecting highly profitable long-term projects.
- Concept: Average Accounting Profit / Average Investment. - Pros: Uses accounting data which is easily available. Considers the entire life of the project. - Critique: It is based on accounting profit (which includes non-cash items like depreciation) rather than actual cash flows. It also ignores the time value of money.
- Concept: Discounts all future cash inflows to present value and subtracts initial investment. - Pros: The theoretically soundest method. It uses actual cash flows, considers the entire life of the project, strictly applies the time value of money using the firm's cost of capital, and shows the absolute dollar amount of wealth added to the firm. - Critique: Complex to calculate. It requires a highly accurate estimate of the firm's cost of capital, which can be difficult to determine.
- Concept: The exact discount rate that makes NPV = 0. - Pros: Considers TVM and whole project life. Gives a percentage return which managers find easier to compare against the cost of borrowing. - Critique: Assumes interim cash flows are reinvested at the IRR rate (which is often unrealistically high) rather than the cost of capital. In projects with non-conventional cash flows (negative flows in middle years), it can yield multiple confusing IRRs.