Why is capital budgeting such an important process? Why are capital budgeting errors so costly? Differentiate between NPV, PI, and IRR methods. What are the advantages and disadvantages of using each of these methods? Why is there a focus on cash flows rather than accounting profits in making capital-budgeting decisions? Why such an interest in incremental cash flows rather than total cash flows?
Capital budgeting is process of decision making with respect to investments made in fixed assets—that is, should a proposed project be accepted or rejected. (Keown 305)
NVP investment proposal is equal to the present value of its annual free cash flows less the investment’s initial outlay measures the net value of the investment proposal in terms of today’s dollars. Because all cash flows are discounted back to the present, comparing the difference between the present value of the annual cash flows and the investment outlay recognizes the time value of money. (Keown 310)
PI is the ratio of the present value of the future free cash flows to the initial outlay (Keown 313) The advantage to using this is
NPV and PI are the same, they have the same advantages over the other criteria examined. Both employ free cash flows, recognize the timing of the cash flows, and are consistent with the goal of maximizing shareholders’ wealth. The major disadvantage of the PI criterion, similar to the NPV is that it requires long, detailed free cash flow forecasts.
Internal rate of return (IRR) the discount rate that equates the present value of the project’s free cash flows with the project’s initial cash outlay (Keown 316)
If the NPV is positive, then the IRR must be greater than the required rate of return, k. Thus, all the discounted cash-flows are consistent and will result in similar accept/reject decisions. The disadvantage of the IRR relative to the NPV deals with the implied reinvestment rate assumptions made by these two methods. The NPV assumes that cash flows over the life of the project are reinvested back in projects that earn the required rate of return. (Keown 317)