Discussion Question - Essay Example

Capital Budgeting Models Capital Budgeting Models Large corporate companies invest in future capital projects that require huge cashoutflow with hopes of making much more cash in the future. However, they face the challenge of change in value of money in the present to that in the future. Therefore, there is need of evaluating, quantifying and estimating the expected returns. According to Gad (2014), this is possible through implementing capital budgeting models which are payback method, net present value, and internal rate of return.

The Payback Method quantifies the time the projects cash inflows will take to equalize with the original investment. Most attractive projects are those whose payback period is very short. The Net Present Value (NPV) indicates whether the expected rates of return is equivalent to, higher, or lower than the company’s preferred rate of return (Gad, 2014). Finally, Internal Rate of Return (IRR) refers to the interest rate that leads to value equalization of the present net cash inflows and outflows.

Thus can be considered the true rate of return of a project where high IRR indicates desirable projects.A conflict among the three capital budgeting models where the NPV indicates rejection, but the IRR and Payback methods both indicated acceptance can a time occur. Such a situation can be brought about by a project having more than one IRR or the interest rate being greater than zero and a very short payback period (Gad, 2014). Analyst, therefore, should accept a situation where the present value of future cash inflow is greater than cost of initial investment.

When using the payback method the emphasis are on cash and its recovery although it overlooks the time value of money and desired return rates. NPV model considers the money value but does not provide actual return rates. The IRR gives the actual return rates but they keep on changing with time. In conclusion, for a correct data that indicates negative NPV but positive IRR and payback method the most accurate decision is to reject the project. This is because NPV measure the wealth creation, profitability and the extent of wealth change expected for the shareholders.

Therefore, a negative NPV indicated a significant decrease of shareholders wealth which directly affects the company cash flow.ReferenceGad sham. (2014). Capital Budgeting: Capital Budgeting Decision Tools. Retrieved from http://www.investopedia.com/university/capital-budgeting/decision-tools.asp