Strategic Corporate Finance

Strategic Corporate Finance

Case Study

Capital Budgeting Methods

There are number of capital budgeting techniques and financial managers have to choose the best technique for the project.

Payback Period Is defined as the time period necessary for the discounted cash flows are able to recover the cost of investment. The payback period represents a calculation of "balance" in the sense that if cash flows are received at the expected rate to the year in which recovery occurs, and then the project will reach its equilibrium point. The recovery period usually does not take into account the cost of capital; any costs attributable to the debt or equity have been used to undertake the project should be reflected in cash flows or in the calculations. The discounted payback period does take into account capital costs, shows the year in which equilibrium will occur after you cover the costs attributable to debts and the cost of capital (Chadwell et al, 2011, pp 95-104).

Both recovery methods provide information about the period of time during which the funds will remain committed to a project. It is better to choose that project that has the payback period shorter. The payback period method is often used as an indicator of the riskiness of the project (Bennouna & Marchant, 2010, pp 225-247).

Net Present Value (NPV)

This method is based on the techniques of discounted cash flow (DCF) is a method for evaluating proposals for capital investment by obtaining the PV of net cash flows in the future, discounted at the cost of capital company or the required rate of return. The techniques of discounted cash flow (DCF) are methods to evaluate investment proposals that employ concepts of the value of money over time, two of these are the net present value method and the method of internal rate of return (Gitman & Maxwell, 2011, pp 41-50).

If NPV is positive, the project should be accepted, while if the NPV is negative, should be rejected. If the two projects are mutually exclusive, one with the highest NPV should be chosen, provided that the NPV is positive. If the financial manager has to choose the best option between two cases, for instance in this case the offshore NPV is positive and higher than the onshore then in this case the financial manger should choose the offshore project because it has the higher NPV. The NPV approach is the best approach in the capital budgeting technique.

Internal Rate of Return (IRR)

It is a method used to evaluate investment proposals by applying the rate of return on an asset, which is calculated by finding the discount rate which makes the NPV equal to zero. The rate of return (IRR) is defined as the discount rate that equates the present value of cash inflows expected from a project with the present value of expected costs. It is better for the project to have the higher IRR. The IRR of the offshore project is more than the onshore, so according to the capital budgeting ...