9 Conclusions about capital budgeting Aa Aa The decision pro

9. Conclusions about capital budgeting Aa Aa The decision process 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. Managers have been slow to adopt the IRR, because percentage returns are a harder concept for them to grasp For most firms, the reinvestment rate assumption in the NPV is more realistic than the assumption in the IRR The NPV shows how much value the company is creating for its shareholders. is the single best method to use when making capital budgeting decisions.

Solution

Choosing correct option:

Statement 2 and 3 are correct.

NPV uses discount rate or WACC as reinvestment rate for cash flows. This is because cash inflows generated from a project are substitutes for external capital and, hence save the firm the cost of outside capital. Therefore, in an opportunity cost sense, a project’s cash flows are reinvested at the cost of capital. So statement 2 is correct.

NPV is mostly used as it is an absolute value that helps to assess how much value will be created for shareholders by the project to be pursued. So statement 3 is correct.

Statement 1 is not correct. IRR is not adopted as it has an unrealistic reinvestment rate assumption. It assumes all cash inflows are reinvested at IRR, which may not always stand true. Hence you might not be able to assess the project purely on an IRR basis.

NPV is the single best method for capital budgeting. This is because, it is an absolute approach that explains what would be the value added by the project to firm. IRR in contrast is a relative approach, which has its own set of disadvantages (like it cannot handle unconventional cash flows, flaw in its reinvestment rate assumption).