Describe the decision rules management should use for accepting and rejecting capital projects under each of the following capital budgeting models: net present value model, internal rate of return model, payback period, and the unadjusted rate of return model.

Question

What will be an ideal response?

Answer 1

Answers will vary.

Management should accept projects whose net present values (NPV) are equal to or greater than zero. Projects with zero net present values are earning exactly the minimum required rate of return while projects with positive NPVs are earning more than the minimum rate. Thus, the higher the net present value the better.

When selecting projects on the basis of the internal rate of return (IRR), management should accept projects whose internal rate of return is equal to or greater than the hurdle rate. The higher the IRR is, the better.

When selecting projects on the basis of payback, the payback must be compared to a threshold set by management. For example, management might stipulate that a project of a certain risk level must recoup its initial investment during the first half of the project's life. The shorter the payback period the better.

Finally, when using the unadjusted rate of return (URR) model, a project should be accepted if its unadjusted rate of return is equal to or greater than the specified hurdle rate. The larger the URR, the better.