Capital Budgeting Essay

914 Words Nov 18th, 2013 4 Pages
Unit VII Paper

Elizabeth Scott


January 13, 2013
Nchacha Etta

Capital Budgeting

When evaluating capital budgeting projects, the internal rate of return (IRR) and the net present value (NPV) methods are two major approaches used. IRR and NPV are the most widely used in capital budgeting. One other approach is the profitability index (PI) is essentially a variation on the NPV method. A question might be if these always give the same solutions to the problems. The answer here is no. This paper will explore these different capital budgeting techniques. This paper will also compare and contrast each of the techniques with an emphasis on comparative strengths and weaknesses. The net
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The two approaches are closely related. As mentioned, the internal rate of return and net present value methods are the two major approaches to evaluating capital budgeting projects. The NPV profile for a project is a graphic representation of the relationship between a project’s NPV and the interest rate at which it is calculated (Lasher, 2011). The NPV profiles can be used to show how the NPV and IRR methods can give conflicting directions when choosing among mutually exclusive projects. Generally the two methods can be expected to agree when the cost of capital is not too far below the project IRRs. NPV has both advantages and disadvantages. The NPV method has advantages for accounting for time value of money and showing the project values added to the firm. Accodring to Chen (2012), NPV is not able to address the flexibility and uncertainty of capital budgeting in the business world. The factors that are affecting business investment will become more complicated and using real options to supplement NPV criterion will be more of a trend (Chen, 2012). According to Altshuler and Magni (2012), there is also disadvantages when using IRR. The IRR calculation itself assumes interim in-vestment values that are mechanically generated byt the IRR equation itself and will almost always differ from the true interim values of the project under consideration. With the extent that these values differ, the IRR result will not be an accurate rate

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