Before making capital budgeting decisions, finance professionals often generate,
ID: 2616966 • Letter: B
Question
Before making capital budgeting decisions, finance professionals often generate, review, analyze, select, and implement long-term investment proposals that meet firm-specific criteria and are consistent with the firm's strategic goals. Companies often use several methods to evaluate the project's cash flows and each of them has its benefits and disadvantages. Based on your understanding of the capital budgeting evaluation methods, which of the following conclusions about capital budgeting are valid? Check all that apply. The discounted payback period improves on the regular payback period by accounting for the time value of money Because the MIRR and NPV use the same reinvestment rate assumption, they always lead to the same accept/reject decision for mutually exclusive projects. For most firms, the reinvestment rate assumption in the MIRR is more realistic than the assumption in the IRR. is the single best method to use when making capital budgeting decisions.Explanation / Answer
The correct statements are: Statement 1 and Statement 3
Discounted payback mitigates the disadvantage associated with regular payback period, which does not account for time value of money and hence is not a good measure for assessment or evaluation of project, especially for long term projects. So statement 1 is correct.
Reinvestment rate assumption in MIRR is more realistic than assumption in IRR. For IRR, it is assumed that all cash flows are reinvested at the same return IRR. MIRR however differentiates the rates for different cashflows - there is a finance rate (that is used for initial cash outlay) and a reinvestment rate as cost of capital (used for future cash inflows). So statement 3 is correct.
Statement 2 is incorrect. MIRR and NPV mostly lead to a conflicting decision. NPV method should be used for assessment, and MIRR using as a supplementary assessment tool, since it is sensetive to finance and reinvestment rate.
NPV is the single best method to use when making capital budgeting decisions - this is because NPV can be used for different sized capital projects, and which last for different duration. Moreover, NPV is an absolute method, which helps assess whether a project adds or reduces value of a firm.
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