Portfolio Project: Capital Budgeting Techniques - Assignment Example

An investment of, let’s say, $100 if yields $50 every year then it’s payback period will be 2 years because the investment is recovered by the investor after 2 years. This is a very simple method to evaluate an investment but it does not take many complicated factors that play a role in capital budgeting decisions. A disadvantage of this technique is that it is not possible to understand the impact of interest rate changes and inflation in the economy. This method also assumes that exact cash flows coming in future are known.

Also it is only a short term measure because some investment gives returns for a longer period of time (Woodruff, 2007). Payback rule is also not a good measure of capital budgeting when initial capital is being borrowed on interest. Internal rate of return is another method to evaluate capital budgeting decisions. Investors can calculated IRR of their investment and determine whether they should take the project or not. Internal rate of return is the rate at which any new project’s net present value becomes zero.

It is usually used in situations where the firm is trying to borrow money in order to finance the whole project. An investment should only be considered if its internal rate of return is better than the borrowing cost. . bly the most commonly used technique of capital budgeting because it compares the cost of the investment with the exact cash flows that investment will yield over a period of time. This allows the investor to get a fair picture of the investment he or she is trying to make. The problem with net present value method is that it makes judgment on the amount of future cash flows which is not always certain.

Not all investors can no beforehand what the investment will exactly yield in coming years. But the method is simple and elegant, and can guide rudimentary level investment decisions precisely. Profitability index is a ratio that is calculated by dividing current value of future benefit that will come from the investment with the initial cost of that investment (Ross, Westerfield, & Jordan, 2012). The higher the profitability index, the higher the return investor can expect to achieve from the investment.

It is another simple method to make capital budgeting decisions but it also assumes that investor has complete knowledge of the cash flows an investment will bring which is usually not the case. This method can give a quick picture of an investment decision in a short period of time and therefore can be used in addition to other techniques. Examples of Capital budgeting techniques In this section we will use hypothetical numbers to better understand different capital budgeting techniques. Let’s say that a company is considering a project that costs $500,000 and is expected to give 80,000 annually for the next 10 years.

If the company wishes to borrow this $500,000 then they will have to bear 8 percent borrowing cost. Discount rate is 5 percent. Using this example all of the abovementioned capital budgeting techniques will be discussed. Payback Rule The investment is