Capital budgeting decision

Whereas 𝐴𝑖=net cash flow in period r=the discount rate

𝐼𝑜=the initial investment

ACCEPTANCE CRITERIA

I. All projects with positive NPV should be accepted because they add value to the firm [NPV > 0, accept]

II. Projects with negative NPV should be rejected because they reduce the value of the firm [NPV < 0, reject]

III. Projects with zero NPV can be accepted depending on the objectives of the investor. A zero NPV implies that, a project generates cash flows at a rate just equal to the opportunity cost of capital. [NPV=0, accept]

IV. When considering several projects, the higher the NPV the better the project.

The NPV method can be used to select between mutually exclusive projects; the one with the highest NPV should be selected. Using the NPV method, projects would be ranked in order of present value; that is, first priority will be given to the project with the highest positive NPV and so on.

Note: 0 year is the 1st year of investment and 1st year of the project is the 2nd year of the investment

ADVANTAGES OF NPV METHODS

I. It takes into account time value of money by discounting cash-flow to their present worth.

II. It uses actual cash-flow and not book profit which is relevant to the objective of wealth maximization. III. It considers all the cash-flows over the entire life of the project.

DISADVANTAGES

• There are difficulties in estimating cash-flows especially when long period of time are involved
• The method is tedious to use when the project cash flows are forecasted over a very long period of time.
• It involves complex calculation which may not be easy to understand by managers who have no formal background of quantitative technique.

IV. It is difficult to determine the discount rate.

N.B: However, NPV is considered to be superior over other techniques because of its advantages.

2. INTERNAL RATE OF RETURN METHOD (IRR)

• IRR is defined as the discount rate that equates the present value of the expected future net cash flow to the initial capital outlay. It is the discount rate that equates the present value of the expected cash outflow to the present value of the expected cash inflow. In other words, the IRR is the discount rate at which NPV=0. It is the discount rate at which the project breaks-even.

• Since we cannot reasonably and quickly determine the discount rate at which the NPV =0 we use trial and error together with either.
• Formula method.