Question

If you were to rank the capital budgeting techniques from best to worst, what would your ranking look like? Be sure to support your answer.

Answer 1

The best capital budgeting technique is the annual net worth method. It provides the value added on an equivalent annual basis and is useful when the alternatives have different useful lives. Next is the net present value method. It takes into account the time value of money by discounting future cash flows. It also goes beyond the payback period and consider all the cash flows involved. It determines the dollar value of value added by undertaking a particular project. The internal rate of return method ranks next. It provides the rate of return on an investment but it fails when there are multiple cash flow signs involved and difference in scale of the projects.

Finally the discounted payback method and payback method are ranked. These assess a project based on the period within which the initial capital is recovered. The discounted method is superior since it considers the discounted cash flows.

Hence Ranking

1: Equivalent annual worth

2: NPV

3: IRR

4: Discounted payback

5: Payback