Discussion: There are many methods for determining a capital budget, and most fi
ID: 2731180 • Letter: D
Question
Discussion:
There are many methods for determining a capital budget, and most financial managers agree that the NPV method is the best. This discussion will help you firm up your understanding of the NPV method, as well as the other options for capital budgeting.
Why is the NPV method for budgeting accepted as the most valuable budgeting tool? If you were not allowed to use NPV for a budget you were developing, what other method(s) would you use? Explain your choices.
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Explanation / Answer
NPV method is the best method for Capital Budgeting decisions as it provides the details of the amount that the investors will get in return using the cost of capital as the discount rate. This is the most rational factor that the cash inflows are considered to be reinvested at Cost of Capital .
NPV also gives the decision in clear terms whether to accept or reject a project based on positive or negative value of NPV.
NPV also indicates the project which gives the maximum return in value terms to the investors so that investors can take the appropriate call.
If the initial investments are different, then Profitability ratio can be used in conjusnction with NPV to decide the best investment.
If NPV cannot be used, then I shall opt for MIRR method , which also reinvests the cash inflows at cost of capital and the investments are also converted into present values if multiple investments are there. MIRR is a better method than IRR as it avoids the duplicate IRR situations and have more reasonable use of cost of capital as reinvestment rate.