Most financial experts will ag
Most financial experts will agree that net present value is thebest capital budgeting method. Explain why this is so and alsoexplain how even NPV can be unreliable when projecting projectresults. Also Given the goal of maximization of firm value andshareholder wealth, we have stressed the importance of net presentvalue (NPV). And yet, many financial decision-makers at some of themost prominent firms in the world continue to use less desirablemeasures such as the payback method. Discuss why you think this isthe case.
Answer:
1. There are many methods of capital budgeting analysis. The netpresent value method is considered the best method due to thefollowing reasons
A. It considers the time value of money which is ignored by manyother methods.
B. It understands the economies of scale and takes into accountthe dollar value of a project.
C. This method considers a rate of borrowing and lending closerto the market rates and hence is more practical.
2. The method however may be unreliable when projecting projectresults due to its sensitivity to discount rates and estimation forfuture cash flows. The assumptions and estimations made could turnthe results net present value calculation all around. Even a smallchange in the discount rate can change the capital budgetingdecisions.
3. Again the difficulties in estimation of the future cash flowsand volatility in the environment which can change the discountrate substantially are the reasons why firms continue to use othermethods such as payback. In times of economic unrest assuming aconstant discount rate over a long period would be impractical andthe net present value method would fail in such a scenario. Thepayback method gives the firms a clear indication of the time inwhich their investment would be recovered.
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