Discuss the two common capital budgeting techniques

Question

What will be an ideal response?

Answer 1

The two common capital budgeting techniques are net present value and internal rate of return.
Net present value (NPV) analysis incorporates the time value of money (acknowledging that a dollar now is worth
more than a dollar later) by discounting the cash flows from the proposed project to their present value using the
discount rate.
The discount rate (the rate by which the cash flows are reduced to reflect the time value of money) is generally the
rate of return that the organization could earn on an investment with similar financial risk.
To calculate NPV, we sum up the discounted cash flows from each year of the proposed project. NPVs greater than
0 mean that the proposed plan generates more discounted cash flow than an investment with equivalent financial
risk, so it is a wise use of capital. To calculate NPV, we use the following formula:
NPV = [(Cash flow from year 0)/(1 + discount rate)t = 0 ] +
[(Cash flow from year 1)/(1 + discount rate)t = 1] + [remaining discounted cash flows]
The other popular capital budgeting technique is the internal rate of return (IRR) analysis, which calculates the rate
of return based on the plan's discounted cash flows and compares it to the company's required rate of return
(sometimes called the hurdle rate). Some companies prefer the IRR technique to that of NPV, because IRR provides
the actual expected rate of return, whereas NPV only indicates a go/no-go decision of a single project, or the
relative attractiveness of multiple projects compared with their respective NPVs. To calculate the IRR, we set NPV
to zero (because the actual rate of return is the same as the "discount rate" when NPV = 0), then solve for the rate of
return.