Question 2 (b)

Capital budgeting decisions: meaning, features, and why NPV and IRR can conflict

7 marks

Time to write
About 14 minutes

From an older CBCS paper

Question

Question 2 (b) · 7 marks

What is meant by capital budgeting decisions? What are its chief features? Why do the NPV and IRR techniques of capital budgeting evaluation lead to a conflicting project ranking?

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 is meant…?What…?Why…?3 asks, each with its own marks below. Answer all 3. Where it asks why, give reasons, not a description.
  • NPVCash flows year by year in one table, then discount, then a one-line decision.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Meaning 1½ marks 1 min
  3. 2 Chief features 2½ marks 5 min
  4. 3 Why NPV and IRR conflict 3 marks 6 min
  5. Check: every ask answered, key terms underlined 1 min

Easy marks

  • Meaning (step 1, 1½ marks): a clear definition and a line on what it covers. It opens the answer, so it takes a minute or two.

Short on time? Keep step 1 short. Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks.

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.

Meaning. Capital budgeting decisions are decisions to invest the firm's funds in long-term assets (plant, machinery, new products, expansion, replacement, diversification, research) whose benefits are expected over a number of years. They are evaluated by estimating the project's cash flows over its life, choosing a decision criterion and determining the required rate of return used to discount them.

Chief features

  1. Long-term effect: the benefits extend over several years and shape the firm's future growth and profitability.
  2. Large funds: substantial amounts are committed at once.
  3. Irreversibility: once made, such investments can be reversed only at a heavy loss, since there may be no second-hand market for the assets.
  4. Risk and uncertainty: the returns lie in the future and are uncertain.
  5. Exchange of current funds for future benefits: so the time value of money must be considered.
  6. Strategic importance: expansion and diversification proposals change the character of the business.

Why NPV and IRR can rank projects differently. For a single conventional project they always agree, but mutually exclusive projects can be ranked differently because of:

  • Size disparity: NPV is an absolute measure and IRR a relative one, so a larger project may have the higher NPV but the lower IRR;
  • Time disparity: projects whose cash flows come early or late rank differently at different discount rates;
  • Unequal lives; and, underlying all three,
  • The reinvestment assumption: IRR assumes intermediate cash flows are reinvested at the IRR, NPV at the cost of capital; and the highest-IRR project need not be the one that maximises shareholders' wealth.

When they conflict NPV is preferred, since it measures the absolute increase in shareholders' wealth and uses the more realistic reinvestment rate.

Where the 7 marks sit

#ComponentMarks
1Meaning1.5
2Chief features2.5
3Why NPV and IRR conflict3
Total7
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