Capital budgeting decision is whether to lease or buy an asset - Essay Example

It is very important to study all capital investments options that are available with the firm because of the long-term consequences. The simplest example of a capital budgeting decision is to decide if a firm should buy an asset or lease the same. Buying the asset will result in capital investments while leasing will lead to operational outflow. Capital budgeting methods In order to evaluate the capital budgeting options available with it, a firm can use many of the following ways: Net Present Value: Net present value is the cash the firm will need today as a substitute of making the investment of purchasing the asset (Ross, Westerfield, Jaffe, 2004).

If the NPV is positive, this means that the firm will get that cash amount equal to the NPV. The calculation of the net present value takes into account the time value of money along with the cash flow associated with the project throughout the lifetime. A project should be pursued if the net present value is positive. Internal rate of return: This is the discount rate that makes the Net Present Value of a project zero. If the IRR of purchasing the asset is greater than the discount rate, the asset should be brought.

Otherwise, the asset should be leased. . Profitability index: The profitability index ratio is an indication of the cost associated with the project viz-a-viz the initial investment made. The ratio can be calculated as: Accounting rate of return: Accounting rate of return is the rate of return that is generated from the proposed capital investment. Each method has its own advantages as well as disadvantages. While NPV calculation is based on too many assumptions including that of the future cash flows as well as the return on equity.

The calculation is also based on the premise that the cash flows generated are invested back at the discounted rate which is not a realistic assumption. The internal rate of return calculation assumes that the returns from the project are re-invested in the project. However, this might not be true in most of the cases. In addition, if the project has multiple positive and negative cash flows, it may have several IRRs. As a result of this, firms shall use modified internal rate of return (MIRR), which is the discount rate that makes the investment equal to the future value of the cash flows from investment (Kierulff, 2008).

The actual method used for capital budgeting decisions differ from firm to firm depending upon the size of the firm, the rate of growth of firm and leverage of firm amongst others. Graham and Harvey (2000) in their paper “The theory and practice of corporate finance: Evidence from the field” indicate that net present value and internal rate of return are the most popular methods used for capital budgeting decision methods. They also concluded that there is no dependence of the method used on the growth rate for firms with smaller debt ratios.

Large firms are more frequent user of NPV as compared to smaller firms. Public companies are more likely to