Question 2 (a)

Discounting techniques of capital budgeting

6 marks

Time to write: About 12 minutes
Topic: Capital budgeting techniques

Question

Question 2 (a) · 6 marks

Briefly explain the various discounting techniques used to evaluate capital budgeting proposals.

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

12 minfor 6 marks

Read from the question

evaluateBoth sides: the strengths, the limits, then your own view.
BrieflyShort headed points, no long paragraphs.

Write it in this order

Read; underline the asks; jot your points 1 min
1 NPV 2 marks 3 min
2 IRR 2 marks 3 min
3 PI 1 mark 2 min
4 Discounted payback 1 mark 2 min
Check: every ask answered, key terms underlined 1 min

1234

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks. End with step 4 in a line or two.

Try it first. About 12 minutes for 6 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.

Discounting (time-adjusted) techniques discount the cash flows at a rate, normally the cost of capital, and take into account the timing of the benefits and costs. NPV, IRR and the profitability index use the cash flows of the project's whole life; the discounted payback period stops once the outlay is recovered.

Net present value (NPV). NPV = present value of the cash inflows at the cost of capital − the initial investment. Accept if NPV is positive, reject if negative. It measures the absolute addition to shareholders' wealth.
Internal rate of return (IRR). The rate at which the present value of the inflows equals the outlay (NPV = 0). Accept if IRR exceeds the cost of capital. It assumes the intermediate cash flows are reinvested at the IRR.
Profitability index (PI) or benefit-cost ratio. PI = present value of cash inflows ÷ present value of cash outflows. Accept if PI > 1; PI > 1 means a positive NPV. Being a ratio, it shows return per rupee invested.
Discounted payback period. The time the discounted cash inflows take to recover the outlay; it improves on the simple payback by allowing for the time value of money.

All four allow for the time value of money; NPV is generally preferred because it measures the gain in wealth directly.

Where the 6 marks sit

#	Component	Marks
1	NPV	2
2	IRR	2
3	PI	1
4	Discounted payback	1
	Total	6

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