Participation Week 6

A company sets itself some rules of investment to decide whether to accept the project or

reject it depending upon the project’s profitability. There are various methods to determine a

project’s profitability which are based on estimated future cash flows during the project. The

discounted present value of the project from the estimated cashflows gives us the Net Present

Value or NPV, which is one of the methods. The other methods are calculating the project’s

Internal Rate of Return (IRR) which is a measure of how soon can the project provide returns

on the investment and payback period (PB) which is a measure of the time it will take for an

investment to break even. Although, none of these methods can guarantee the profitability

factor of an investment as they are based on predictions and estimations, therefore it is better

to check the profitability of a project by using all the three methods and reach at the same

conclusion. Only if the project’s profitability is accepted through all three methods, a project

can be considered as a safe investment.

Due to these estimations and predictions, the results are not guaranteed. The companies want

to remain profitable and try to make only those investments which can provide nearly

guaranteed returns so they continuously remain profitable in order to attract shareholders.

Therefore, the companies set some rules of investment in the form of thresholds of value

based upon their previous investment experiences, assessing the risk factor, exploring the

potential environment of the project, interpreting the results fairly with transparent

communication (Hildreth, 2021) through which they decide whether to accept or to reject the

project. Sometimes, the results through each of these methods may contradict one another

which is why the rules of capital budgeting also may include the preference of one of these

three methods over another which depends upon the company itself. For example, if a

company can only invest in one project at a time, they would want to recover the amount of
investment as soon as possible to ensure short term availability of capital or liquidity which

would see them prefer the Payback Period method. If a company wants to invest in another

project while one project is undergoing, they would prefer the IRR method so they can

recover their initial investment amount faster and reinvest it into another project.

References-

1. Hildreth, W.B. (2021). Capital Budgeting and Debt Financing. Teaching Public

Budgeting Finance. 75-108.