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Primary Drawbacks of Net Present Value as Capital Budgeting Technique - Assignment Example

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Primary Drawbacks of Net Present Value as Capital Budgeting Technique

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. ...
A decision regarding a particular investment opportunity that is based on NPV technique will find itself under scrutiny when assessed using IRR technique. While this fact is not true for independent projects where both techniques will yield similar results, but when it comes to mutually exclusive projects (one project or the other) these tools do not yield a consistent result. The reason behind this conflict is that the set of investment opportunity that is being assessed consists of projects that vary in their size and timings of their future cash flows (Helfert, 2004). So it is clear that if a company is deciding between two investment opportunities, it will encounter a problem when it is using NPV and IRR to assess the value of these investment opportunities for the company. In this conflicting situation the company shall have to decide whether it will make its decision based on NPP or IRR (Helfert, 2004). Question # 3: Avenues to raise equity for a Profit Driven Firm: A profit driven firm, if assumed to be a corporation, has multiple options at its disposal to raise new equity capital. The first option that it has is to go to its existing shareholder for additional capital. The second option it has is to add more shareholders into the company by offering new share in the primary market. The third option available to a profit driven firm is that it can seek help from a venture capitalist firm; again this will be in exchange for some portion of the company’s equity. The fourth option available to the company is that it asks a bank for a loan in return for interest payments. These mentioned options are most suited to meet the company’s short-term capital requirement ...Show more

Summary

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…
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