The capital budgeting decision techniques discussed so far all have strengths an

Question

The capital budgeting decision techniques discussed so far all have strengths and weaknesses; however, they do comprise the most popular rules for valuing projects. On the other hand, valuing an entire business requires that some adjustments be made to various pieces of these methodologies. As an example, in valuing a business, one frequently used alternative to Net Present Value (NPV) is called Adjusted Present Value (APV).

Identify and discuss at least two other business valuation models that are popular.

Explanation / Answer

1) Pay back period :

It is nothing but time the project will take to get cash inflows from the project o equal the cash outflows made intially usually in years,this is when deciding between two or more exclusive projects.The generally the project with shortest payback period will be selected.

Pay back is often used as a first screening method.By this we mean that when a capital project considered,the first question to ask is how long will it take to pay back its cost.Normally the company might have some target payback and so it would reject a capital project unless its payback period is less than a certain number of years.

Pay back period = Initial cash flow / Annual cash inflows

2) Accounting rate of return :

The ARR method is considered as one of the method for appraising capital projects.Normally every company should have some target return, If the ARR exceeds the target return then the project shall be undertaken.ARR is nothing but return on capital employed or return on the investment.

ARR on total investment = Net annual profit / Investment outlay

Note that net annual profit excludes depreciation.

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