Business Accounting - Essay Example

The project is acceptable as both methods show positive outcome in terms of payback period as well as PV of net inflow of the project. Risk is inherent in almost every business. This is more prominent in capital decision making as such decisions involve cost and benefit extending over a period of time. During this long period of time many thing get changed in an unexpected way and hence the risk of return is always there in capital budgeting decisions. The project under consideration carries a medium level of risk.

At the same time it is given that the company’s estimate of future cash flows of 10% is too high. A higher discount rate means higher returns. The principal is that higher the risk higher is the returns. If the company considers the medium level of risk for investments under consideration, then this 10% rate calculated on an estimate of higher risk level require suitable adjustments. In other words the rate of discount has to be lowered to the accepted level of medium risk. The company should develop a risk adjusted discount rate.

If the company considers the risk of the project equal to the risk of existing investments of the company, then the discount rate of average cost of capital should be considered for evaluating the project. When the risk of the project is greater than the risks of existing investments, then the discount rate used should be higher than average cost of the capital employed with the company. If the risk of the project is lower than risk of existing investments, the discount rate used to evaluate the project should be lower than the average cost of capital employed.

In our case the company is expecting medium risk on the project, it is suggestible that average cost of the capital employed be considered as the discount rate to project future cash flows and then discount those cash flows at present value at that average rate of discount in order to compare with present value of net outflows. The calculated discount rate