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Pros and Cons of Capital Budgeting Measures - Research Paper Example

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Pros and Cons of Capital Budgeting Measures

Examples here include the payback period and the accounting rate of return. The other techniques employed in the evaluation of projects are the discounted methods of appraising capital projects. In these methods, the future expected cash flows are discounted at the organizations cost of capital to determine the projects’ to be undertaken. In this approach, only projects with positive net present value will be undertaken in order of their profitability. The idea of capital budgeting before investments are undertaken is necessitated by the need to avoid incurring losses and to maximize the returns of a firm at the lowest cost possible. The budgeting process is also necessary because of the capital constraints that companies face. Due to capital inadequacy, companies and firms will not be in a position to undertake all the projects and therefore creating the need to only undertakes the most profitable investments (Baker, 2011). Failure to undertake capital budgeting process may cause organizations to realize heavy losses and have going concern problems. In this paper, discussion has made on the pros and cons of the methods of NPV, IRR, MIRR and discounted payback method. I would prefer the use of NPV and IRR methods of capital budgeting in instances that we have independent projects with equal sizes. The two methods can thus be used interchangeably and would be preferred because they incorporate the risk and time values in their calculations. MIRR, which is an improvement of IRR, is also preferable in cases where we have projects having irregular cash flows and therefore provides a solution to some of the short falls of IRR. Investment appraisal should therefore be keenly undertaken by qualifies personnel and all necessary weights should be integrated when determining the best method to use. It must be noted that all the methods used in capital budgeting measures have some limitations (Brigham & Ehrhardt, 2010). The best that should be done is to ensure that such deficiency does not impair materially the decision to be made. Net Present Value The NPV of a project is the present value of all the future expected cash inflows less the present value of the future expected cash outflows (Parrino & Kidwell, 2009). In this case, the future expected cash flows are determined currently and discounted using the cost of capital of the firm. NPV takes into account only cash flows and does not use the accounting profits or items like depreciation. It is commonly used by many organizations in their investment appraisal method. Most businesses and organizations that are interested in the viability and profitability of projects have normally applied the NPV method as a way of evaluating their actions. The wide acceptance of NPV is because it is easier to understand and to interpret the results even to those without financial knowledge. NPV has various advantages. To begin with, the method considers the time value of money and therefore shoulders the effect of inflation and interest rates that are likely to adverse affect the value of money. It must be noticed that the value of 1 dollar today may not be the same as the value of the same dollar in 3 years time because of time difference. The second reason for use of this method is that it gives the criteria to use in the selection of the projects to be undertaken. The firms may undertake investments with positive NPV’s because they have a net gain as opposed to those with negative NPV’s which results into losses. The investors or firms are ...Show more

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PROS AND CONS OF CAPITAL BUDGETING MEASURES Date Executive Summary Organizations have to do investment appraisal before undertaking long-term projects in order to determine the feasibility and profitability of their investments…
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Pros and Cons of Capital Budgeting Measures essay example
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