Which of the following statements about capital budgeting methodology are true?

Question

Which of the following statements about capital budgeting methodology are true?

(1) Projects with a net present value greater than or equal to zero are generally considered acceptable

(2) Projects with an internal rate of return greater than the risk-free rate are generally considered acceptable

(3) Projects with a profitability index greater than or equal to one are generally considered acceptable

(4) Projects with a payback period less than 10 years are generally considered acceptable

a. 1 and 3

b. 1, 2, 3 and 4

c. 1, 2 and 3

d. 1 and 2

Explanation / Answer

1) Net present value is the sum of present value of all cash flows of the project. All cash outflows will be in negative sign and all cash inflows would be in positive sign. A project which has sum of present value of all cash inflow greater than sum of present value of all cash outflows will be considered as a project that will add value to the firms. If sum of present value of cash inflows is greater than sum of present value of all cash outflows then NPV is greater than zero.

NPV of zero means sum of present value of all cash inflows is equal to sum of present value of all cash outflows

We should always choose the project that will add some value to the firm.

So the projects with net present value greater than or equal to zero is considered acceptable.

2) Internal rate of return is the rate which will make net present value equal to zero. We compare internal rate of return with required rate of return not risk free rate. Required rate of return is greater than risk free rate. We choose the project which has internal rate of return equal to or greater than required rate of return.

3) Profitablity index is calculated as = present value of all future cash flows / initital investment

Value of profitability index of 1 is minimum reu=quirement for project acceptability as value lesser than that will return less money than initial investment which is not acceptable. At least return should be more than initial investment

Therefore, profitability index with greater than or equal to 1 is considered acceptable

4) Payback period tells in how much time project will return its initial investment. There is no such criteria of how many years we should accept

Therefore, the answer is option 'a' i.e. 1 and 3

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