Why is it important that major capital projects – those which will require a sig

Question

Why is it important that major capital projects – those which will require a significant up-front investment and produce a return over multiple future periods be carefully analyzed and compared to each other before a decision to proceed is approved? How can a simple tool like “Payback Period” help us evaluate a project’s attractiveness by itself as well as against other projects? Why is using time value of money tools like NPV important? How can we factor in the amount of risk inherent in various projects as we perform the analysis?

Explanation / Answer

While investing in a project, it is very important that we get good returns. that is the major purpose of chosing a project. because not all projects will give us good returns. some projects may give good returns initially and later may suffer loss.. some may not pick up gradually but do very well in the future. therefore we need to use various capital budgeting techniques before chosing a project.

Pay back period refers to the period in which the cost of investment in a project is recoverd. if a payback period is very long, it is desiable to not select that project. similarly if payback period is short, it is one factor favourable for the project to be chosen.

NPV is a method that compares money received today as against money received in future while accounting for time and interest. It stresses on how time impacts on the value of money.

It is because there are three main reasons to this theory.

One is a money can be invested today and can earn interest over time by giving it potential earning power.

Else it can be subjected to economic factors like inflation subjected to time making its value much lesser in future.

Mostly there is another risk of not receiving the money in future. So estimating the risk is not easy and these are the reasons we may have to use time value of money tools like NPV while selecting a project.

Also there is always an uncertainty towards anything. understanding that uncertainity will be easier with these tools. Moreover NPV risk analysis is used to make choices between mutually exclusive options.

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