Capital Budgeting Decision Making
Introduction
Capital budgeting is a building process that is used to determine if either long-term investment is
beneficial for the company and will provide the expected returns in the coming years. It is essential
because capital expenditures require large sums of money, so companies must ensure that they will
be profitable before attempting to make such a capital expenditure.
Body
Question 1
For Project 1, NPV will be used. The difference between the current value of cash inflows and
withdrawals over a period of time is known as net present value (NPV). The net present value
(NPV) is a calculation used in capital budgeting and capital planning to determine the profitability
of a proposed investment or project. It takes the time worth of money into account and may be
used to evaluate similar investment options. Any venture or project with a negative NPV should
be avoided since it is based on a discount rate that may be computed from the cost of capital
necessary to undertake the venture.
Pros
Cons

It takes into account the temporal worth of money.

It takes into account all of the project's financial flows.

Using the cost of capital, it assesses the risk in the project cash flows.

It shows if the investment will add value to the project or the firm.

It might be difficult to calculate a discount rate that appropriately reflects the
investment's genuine risk premium.

A corporation may choose a cost of capital that is just too high or too cheap,
causing it to lose out on a profitable opportunity or make an unwise
investment.
For Project 2, Discounted Payback Period will be used. The discounted payback period is an
investment appraisal method for determining a project's viability. By discounting future cash flows
and appreciating the value of money, a payback method calculates the amount of years it takes to
break even on an original investment. The statistic is used to determine a project's profitability and
financial position. The faster a project or investment generates cash flows to repay the initial
investment, the lower the discounted payback time.

Pros
Many company executives prefer discounted payback periods because they
take into account the time worth of money when determining the payback
term.

It analyzes whether or not a project's risk is real and whether or not the
investments invested are recoupable.

Cons
It is unable to assess whether or not the investment would boost the firm's
worth.

It does not take into account any projects that will last longer than the payback
term.

All computations beyond the discounted payback period are ignored.

It does not provide the management with all of the information needed to
make an investment choice.
Question 2
Calculations:
NPV
Here,
NPV stands for Net Present Value.
NCF refers to a period's net cash flow.
I = Interest Rate or Discount Rate.
RV stands for Residual Value.
N stands for the total number of periods.
t = The time interval during which the Cash Flows occur.
Therefore,
NPV for Project 1:
Option A: $166,668.72
Option B: $154,197.59
Discounted Payback Period
For Project 2,
Option 1: 36.90 years
Option 2: 50 years
For Project 1, Option A would be selected because it has greater NPV.
For Project 2, Option A would be selected because it has less payback period.
Conclusion
Capital budgeting is a building process that is used to determine if either long-term investment is
beneficial for the company and will provide the expected returns in the coming years. The most
accurate methodology for investment decision activity is net present value (NPV), because it is
obvious that the final aim of any trade is to increase the ownership of the investors, a financial
adviser always should strive in the interests of the shareholders by finding and selecting enterprises
with a positive net present value.