Capital Budgeting Techniques Research Paper Example | Topics and Well Written Essays - 500 words

Capital Budgeting Techniques - Research Paper Example The purpose of this paper is to describe these techniques and to compare and contrast the pros and cons associated with each of these four capital budgeting techniques. The payback period is used to quantify the expected number of years required to recover the original investment made on a project based on the cash flows that the project generates over its lifetime. The main advantage of this capital budgeting technique is its simplicity. The way to calculate payback period is by adding up the expected cash flows for each year until the original investment of the project is recovered. The basic logic of the method is that it is better to recover the original investment sooner than later. A disadvantage of the payback period method is that it disregards the time value of money. Another capital budget technique to evaluate projects is the net present value or NPV. This method evaluates capital investment projects by finding the present value of future net cash flows, discounted at the rate of return required by the firm (Besley, et al. 2000). One of the pros associated with this capital budgeting technique is that it takes into consideration the time value of money. A project is accepted based on this technique if the NPV output is above cero, while projects that have a negative NPV should be rejected. A disadvantage of the NPV method is that it does not measure the interest rates, profitability, and other benefits relative to the amount invested (Glann, 2009). A third capital budgeting method is the internal rate of return or IRR. The internal rate of return is the rate of return the firm expects to earn if the project is purchased; thus it is defined as the discount rate that equates the present value of a project’s expected cash flow to the investment outlay, or initial cost (Besley, et al. 2000). A pro of the IRR method is that it takes into consideration the time value of money. A project evaluated based on IRR is accepted if the IRR result is greater