Question 2 (a)

Discounted cash flow techniques of capital budgeting

5 marks

Time to write
About 10 minutes

From an older CBCS paper

Question

Question 2 (a) · 5 marks

Explain the Discount Cash Flow Techniques used to evaluate the Proposals of Capital Budgeting.

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

10 minfor 5 marks

Read from the question

  • evaluateBoth sides: the strengths, the limits, then your own view.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Meaning of DCF 1 mark 1 min
  3. 2 NPV, IRR, PI and discounted payback 3½ marks 6 min
  4. 3 Merits over traditional methods ½ mark 1 min
  5. Check: every ask answered, key terms underlined 1 min

Easy marks

  • Meaning of DCF (step 1, 1 mark): a definition in one or two lines. It opens the answer, so it takes a minute or two.

Short on time? Step 2 carries 3½ of the 5 marks: guard its minutes.

Try it first. About 10 minutes for 5 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.

Discounted cash flow (DCF) techniques recognise that a rupee received later is worth less than a rupee now: every cash flow of a proposal is discounted to its present value at the required rate of return.

  1. Net present value (NPV): the present value of the cash inflows less the present value of the outflows; a project is accepted if its NPV is zero or positive (zero being the break-even case); among mutually exclusive projects, the one with the highest positive NPV is selected.
  2. Internal rate of return (IRR): the discount rate at which the NPV is zero; accept if it equals or exceeds the cost of capital (equality being the break-even case). NPV and IRR give the same accept/reject signal for a single conventional project but may rank mutually exclusive projects differently.
  3. Profitability index (PI): PV of inflows ÷ PV of outflows; accept if it is 1 or more.
  4. Discounted payback period: the time taken to recover the outlay from discounted cash inflows.

All of them recognise the time value of money, and NPV, IRR and PI also consider every cash flow of the project (discounted payback ignores those after the outlay is recovered); that is why they are preferred to the traditional payback and accounting-rate-of-return methods.

Where the 5 marks sit

#ComponentMarks
1Meaning of DCF1
2NPV, IRR, PI and discounted payback3.5
3Merits over traditional methods0.5
Total5
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