[Solved] Which one of the following methods of Capital Budgeting assu (2024)

Capital budgeting is a process used to determine whether an organization's long-term investments are worth the funding of cash through the firm's capitalization structure. Itis a method of estimating the financial abilityof capital investment over the lifespan of the investment.

Capital budgeting methods include Net Present Value, Accounting Rate of Return, Internal Rate of Return, Discounted Payback Period, Payback Period, Profitability Index.

Internal Rate of Return:

• It is the discount rate that makes the Net Present Value equal to zero.
• That means in this method discounted cash inflows are equal to discounted cash outflows.
• As long as the initial investment is a cash outflow and the leadingcash flows are all inflows, the Internal Rate of Return method is accurate.
• This method assumes that cash-inflows are reinvested at the project's Internal Rate of Return.

Therefore, the Internal Rate of Return is a method ofCapital Budgeting that assumes cash-inflows are reinvested at the project’s rate of return.

Net Present Value (NPV):

• The Net Present Value is the amount by which the present value (PV) of the cash inflows exceeds the present value of the cash outflows.
• On the contrary,if the present value of the cash outflows exceeds the present value of the cash inflows, the Net Present Value is negative.
• Therefore, NPV = PV of cash inflows - PV of cash outflows.
• Investment plans are accepted when NPV is positive and rejected when NPV is negative.

Accounting Rate of Return (ARR):

• It is a financial ratio that looks at the total accounting return for a project to check if it meets the target return.
• ARR is a percentage return and does not take into account the time value of the money.
• It calculates the return generated from the net income of proposed capital investment.

Discounted Payback Period:

• The Payback period does not take into account the time value of money due to which this method was created.
• This method discounts the future cash flows back to their present value so that theinvestment and the sourcesof cash flows can be compared at the same time period.
• The discount rate for a company may represent its cost of capital or the potential rate of return from an alternative investment.