Question 2 (a)

Main techniques of capital budgeting

7 marks

Time to write
About 14 minutes

From an older CBCS paper

Question

Question 2 (a) · 7 marks

What are the main techniques of capital budgeting? 7

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

14 minfor 7 marks

Read from the question

  • What areThe meaning first, then the main points.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Payback period and ARR 2½ marks 4 min
  3. 2 NPV, IRR, PI and discounted payback 3½ marks 6 min
  4. 3 Assessment 1 mark 2 min
  5. Check: every ask answered, key terms underlined 1 min

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks. End with step 3 in a line or two.

Try it first. About 14 minutes for 7 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

Capital budgeting techniques fall into two groups: traditional (non-discounting) and discounted cash flow (time-adjusted) methods.

A. Traditional methods

  1. Payback period: the years needed to recover the outlay from the cash inflows (cumulated, with interpolation, when inflows are unequal); accept if within the maximum acceptable period. Simple and a guide to liquidity and risk, but it ignores the time value of money and inflows after payback.
  2. Accounting (average) rate of return: average annual profit after tax ÷ average investment; accept if it equals or exceeds the minimum rate. It uses accounting profit and ignores the time value of money.

B. Discounted cash flow methods

  1. Net present value (NPV): the present value of the cash flows at the required rate of return (the cost of capital) less the outlay; accept if it is zero or positive.
  2. Internal rate of return (IRR): the discount rate at which the present value of the inflows equals the outlay; accept if it equals or exceeds the cost of capital.
  3. Profitability index (PI): present value of inflows ÷ outlay; accept if it is 1 or more. A relative measure, useful when funds are limited.
  4. Discounted payback: the payback period computed on discounted cash flows.

Assessment. The discounted methods recognise the time value of money, and NPV, IRR and PI also consider all the cash flows (discounted payback ignores those after recovery), so they are conceptually superior; NPV is preferred when methods conflict, because it measures the absolute increase in shareholders' wealth. The traditional methods remain useful as quick screens.

Where the 7 marks sit

#ComponentMarks
1Payback period and ARR2.5
2NPV, IRR, PI and discounted payback3.5
3Assessment1
Total7
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