SUBMIT TO: Prof.

Ayyub Arshad
SUBMIT BY: Alina Amir Sheikh
ROLL NO: M1F17BBAM0001
SUBJECT: Financial Management
PROGRAM: BBA
SEMESTER: 6TH
TOPIC: Numerical, pros and cons of different
capital budgeting

Project N
Year cash inflow (CF1)

1 10000 11000

2 10000 10000

3 10000 9,000

4 10000 8,000

Calculate each project payback period

Project M: initial investment/ average cash flow

= 28500/10000

= 2.85 years

= 2+[ ($27000-$21000)/$9000]

= 2+6000/9000

=2.67

(B) Calculate the present value (NPV)for each project:

Project M= present value of cash flow – initial value

10000(PVIF14%, 4years)-28500

= ($10000*2.914)-$28500

=$640

Project (N)

Year CFt PVIF(14%) PV=CFT*PVIF

1 $1100 0.877 $9,647

2 10000 0.769 $7690

3 9000 0.675 $6075

4 8000 0.592 $4736

PV (cash inflows) $28,148

Initial investment 27000

NPV $1,148

(C) Calculate the profitability index:

Project M = present value of cash flow/ initial value

=$29,137/$28,500

= 1.02

Project N

Years cash flow PVIF14% PV

0 27000 1

1 11000 0.8772 9649.2

2 10000 0.7695 7695

3 9000 0.6750 6075

4 8000 0.5921 4736.8

28156

= 28156/27000

=1.04

Project N will be accepted

(D) Calculate the internal rate of return (IRR) for each project:

Discount rate(%) NPV(M) NPV(N)

 $11,50

0 0 $11000

5 6,960 6,903

10 3,199 3,490

15 50 618

16 -518 99

Project M:

IRR=15.086

Project N:

IRR: 16.1935%

e. Summarize the preference dictated by each measure you

calculated, and indicate which project you would recommended.
Explain why?
I will select NPV because IRR value is greater and payable period are less. NPV is more and
its profitability index is also higher. After all the analysis, project N would be the best choice because
of the following reason. First, it has a higher NPV. Second, the payback period is shorter thans project
M’s period back. Third project N has higher IRR. The last reason is that NPV has much ‘higher
power’ than IRR since it ranks Capital Budgeting Ranks.

QUESTION NO. 2
What are the pros and cons of different capital
budgeting techniques?
Capital budgeting:
Capital budgeting is the process a business undertakes to evaluate potential major
projects or investments. Construction of a new plant or a big investment in an outside venture are
examples of projects that would require capital budgeting before they are approved or rejected. When
a company is looking at, for example, acquisitions of other companies, development of new lines of
business or major purchases of plants or equipment, capital budgeting is the method used to determine
whether one option is better than another. There are several capital budgeting methods, each with its
pros and cons.
 Pros and cons of Capital Budgeting
Capital Budgeting by Payback Period

The most-used method of capital budgeting is determining the payback period. The company
establishes an acceptable amount of time in which a successful investment can repay the cost of
capital to make it. Investment alternatives with too long a payback period are rejected.
Investment alternatives inside the payback period are evaluated on the basis of the fastest
payback.

Payback method disadvantages include that it does not account for the time value of money.

Net Present Value Capital Budgeting

In net present value capital budgeting, each of the competing alternatives for a firm’s capital is
assigned a discount rate to help determine the value today of expected future returns. Stated
another way, by determining the weighted average cost of capital over time, also called the
discount rate, a company can estimate the value today of the expected cash flow from an
investment of capital today. By comparing this net present value of two or more possible uses of
capital, the opportunity with the highest net present value is the better alternative.

A disadvantage of the net present value method is the method's dependence on correctly
determining the discount rate. That calculation is subject to many variables that must be
estimated.

The Internal Rate of Return Method

An advantage of capital budgeting with the internal rate of return method is that the initial
calculations are easier to perform and understand for company executives who may not have a
financial background. Excel has an IRR calculation function.

The disadvantage of the IRR method is that it can yield abnormally high rates of return by
overestimating the value of reinvesting cash flow over time.

A Modification of the Internal Rate of Return Method

The modified rate of return method overcomes the tendency to overestimate returns by using the
company’s current cost of capital as the rate of return on reinvested cash flow.

As with all methods of capital budgeting, the modified rate of return method is only as good as the
variables used to calculate it. However, by using the firm’s cost of capital as one variable, it has a
figure that is grounded in a verifiable current reality and is the same for all alternatives being
evaluated.

The Accounting Rate of Return

Many financial professionals in a firm, as opposed to top management, prefer the accounting rate
of return because it is most grounded in actual numbers. Determining an investment’s accounting
rate of return is a matter of dividing the expected average profit after taxes from the investment
by the average investment. However, as with the payback period method, it does not account for
the time value of money.