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Primary Drawbacks of Net Present Value as Capital Budgeting Technique
Finance & Accounting
Pages 6 (1506 words)
Question # 1: Primary Drawbacks of Net Present Value as Capital Budgeting Technique: This method or tool is used to assess the profitability of an investment opportunity. This tool is classified as one of the capital budgeting technique that is used by a firm to assess the viability of a project…
This entire process has multiple loopholes, for instance the uncertainty that is prevailing when it comes to estimating future cash flows of that investment opportunity is high enough to put this technique under scrutiny. Next loophole is regarding the discount rate that is used to reach the present value of a cash flow. Again the accuracy of discount rate used is of critical importance in determining the correct value of the cash flow’s present value. This makes NPV value dependent or sensitive to the value of discount rate and forecasted cash flows. Third loophole that is pretty much evident from the assessment of this tool is that this tool takes into account information that is present at the time of decision making, thus it does not take into account changes in the initial conditions of an investment opportunity. The fourth loophole that can be seen is that this tool is only applicable when projects being assessed are tangible and quantifiable. And in reality firms undertake certain projects that are aimed at enhancing the brand equity, such projects are out of the scope of NPV (Kent & English, 2011). Question # 2: Comparison of Net Present Value and Internal Rate of Return: This tool or technique is another capital budgeting technique. IRR is the discount rate that turns the net present value of forecasted cash flows from an investment opportunity equal to zero. ...
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