Internet Explore the Capital Budgeting Research Paper

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The IRR too does not distinguish between the positive investing or negative borrowing+ investing situation, whilst the NPV makes a clear distinction.

NPV is superior to IRR for mutually exclusive investments. Finally, NPV and IRR make different assumptions when it comes to reinvestment assumptions. This can result in conflicts and crossover in ranking of mutually exclusive projects.

Profitability Index (PI)

The PI calculates the present value of a project compared to its cost. It is the sum of the present values of the project divided by the initial cost of the investment.

(Algorithm: PI = NPV / Investment)

Profitability Index Decision Rule

When faced with mutually exclusive investments with capital rationing (i.e. A limit on the amount of funds available for investment), choose the project with the highest PI. (FIN 301)

PI is only used in connection with capital rationing.

Payback Period

This is the number of years that it takes for the total cash net flows of a project to accumulate to the cost of the initial cash outlay. or, in the other words, the length of time that it takes to recover the initial cost of the investment.

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(Algorithm: Cost of Project

Annual Cash Inflows)

For budgetary reasons, it is often best to choose the project that has the shortest Payback Period, but if both projects are independent one can choose both.

Advantages and Disadvantages of PB:

Payback serves as useful measure for assessing the profitability of one project compared to another. It also serves as helpful measure of risk and liquidity of projects.

On the other hand, PB ignores the time value of money as well as ignores the possibility of cash that comes in after the PB period has ended. It is also the least attractive of the other budgetary options for shareholder wealth not taking shareholder maximization into consideration.

In short, each of the above four metric methods are popularly used to determine profitability of a particular project / budgeting option. Ideally, each should come to the same conclusion, but they often produce contradictory results. Depending on the management's preferences, therefore, emphasis is usually placed on one metric above the other, and most managers seem….....

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