Capital budgeting - Essay Example

The criteria for selection of projects is that any project evaluated having positive NPV should be undertaken. This method has the advantage of being that it recognizes the time value of money and risks associated with projected future cash flows. However, it has the limitation of not taking into account the scarcity of capital, and secondly, it’s overly simple (Baker and Kent 2005 pp. 234-86). The profitability index is also known as a cost-benefit ratio it works by ascertaining whether an investment is viable and how much profit will result from it.

PI is evaluated as follows;Profitability Index = (Net Present Value + Initial Investment) / Initial InvestmentThe criteria for accepting a project is that if the PI is greater than one it should be accepted otherwise it should be rejected. Its drawbacks and advantages are similar to those of NPV (Pogue 2010 pp.86-146).IRR as investment evaluation technique is widely accepted and cushions against NPV and PI limitations. An internal rate of return also known as the discounted cash flow rate of return offers a means to financial analysts to quantify the rates of return an investment is envisioned to bring if implemented.

It is calculated NPV =∑_(n=0)^N▒Cn/〖(1+r)〗^n = 0 Which is equivalent to NPV/(1+IRR)^year) of all positive and negative cash flows While evaluating investments using IRR any project which has an internal rate of return greater than the opportunity cost of a project usually taken to be a weighted average cost of capital-WACC are accepted.