Capital Budgeting Basics: Time Value of Money, NPV, IRR, Payback and Investment Decision Rules Questions

Question 1

Explain the importance of capital budgeting (any three points).

Accepted Answer

**Capital budgeting** is important because it:
- Involves **large funds** and long-term commitment.
- Affects **profitability and growth** of the firm for many years.
- Decisions are often **irreversible**, so wrong choices cause heavy losses.

Hence firms evaluate projects carefully using **NPV/IRR** methods.

Question 2

Differentiate between cash flows and accounting profit in capital budgeting.

Accepted Answer

Capital budgeting uses **cash flows**, not **accounting profit**.

- **Accounting profit** includes non-cash items like **depreciation** and accounting adjustments.
- **Cash flows** reflect actual money received/paid and are used to compute **PV/NPV**.

Therefore project evaluation is based on **cash inflows/outflows**.

Question 3

Define capital budgeting.

Accepted Answer

**Capital budgeting** is the process of evaluating and selecting **long-term investment** projects based on expected cash flows.

Question 4

What is time value of money (TVM)?

Accepted Answer

**TVM** means **₹1 today is worth more than ₹1 tomorrow** because money can earn interest.

Question 5

Define NPV.

Accepted Answer

**NPV** is **PV of cash inflows − PV of cash outflows (initial investment)**.

Question 6

What is IRR?

Accepted Answer

**IRR** is the **discount rate** at which **NPV becomes zero**.

Question 7

What is payback period?

Accepted Answer

**Payback period** is the time required to recover the **initial investment** from project cash inflows.

Question 8

Write the decision rule for NPV.

Accepted Answer

Accept a project if **NPV > 0**.

Question 9

Explain payback period method with one merit and one limitation.

Accepted Answer

**Payback period** is the time needed to recover the **initial investment** from cash inflows.

**Merit:** simple and focuses on **liquidity/risk**.
**Limitation:** ignores **time value of money** and ignores cash flows after payback.

So it is a basic screening method.

Question 10

Explain NPV method and its decision rule.

Accepted Answer

**NPV** is the net value added by a project in present value terms.

**Formula:** **NPV = PV of inflows − Initial investment**
**Decision rule:** **Accept** if **NPV > 0**, reject if NPV < 0.

NPV considers **TVM** and **all cash flows**, so it supports wealth maximisation.

Question 11

Explain IRR method and its decision rule.

Accepted Answer

**IRR** is the **discount rate** at which **NPV = 0** (PV inflows = PV outflows).

**Decision rule:** Accept if **IRR ≥ cost of capital** (required rate of return).

IRR is expressed as a **percentage**, so it is easy to compare with required return.

Question 12

Differentiate between NPV and IRR (any three points).

Accepted Answer

**NPV vs IRR** (any three):
- **NPV** gives value in **₹**, while **IRR** gives a **% rate**.
- **NPV** accepts if **NPV > 0**; **IRR** accepts if **IRR ≥ cost of capital**.
- **NPV** is directly linked to **wealth maximisation**; **IRR** can face issues like **multiple IRRs** in non-normal cash flows.

Both consider **TVM**.

Question 13

Explain capital budgeting and its importance. Also write the steps of capital budgeting process (flow).

Accepted Answer

**Capital budgeting** is the process of evaluating and selecting **long-term investment projects** such as new plant, machinery, expansion and replacement.

### **Importance** (why it matters)
- Involves **large funds** and long-term commitment.
- Projects generate cash flows over many years, so **risk/uncertainty** is high.
- Wrong decisions are often **irreversible** and cause heavy losses.

### **Basic capital budgeting process** (flow)
```text
Identify project → Estimate cash flows → Choose discount rate (cost of capital)
→ Evaluate (NPV/IRR/Payback) → Select/Reject → Implement & Review
```

Thus, firms use capital budgeting to achieve **profitability and growth** in the long run.

Question 14

Explain time value of money (TVM). Write PV and FV formulas and show how discounting is used in project evaluation.

Accepted Answer

**Time Value of Money (TVM)** means **₹1 today is worth more than ₹1 tomorrow** because money can earn a return.

### **Key formulas**
| Concept | Formula | Meaning |
|---|---|---|
| **Future Value (FV)** | FV = PV(1+r)^n | value after n years |
| **Present Value (PV)** | PV = FV/(1+r)^n | today’s value |

### **Why TVM is used in capital budgeting**
- Project cash flows come in different years; to compare them, we convert them into **present values** using **discounting**.

So, methods like **NPV** and **IRR** are better than simple payback because they consider **TVM**.

Question 15

Explain NPV method and compare it with payback period method using a table.

Accepted Answer

### **NPV (Net Present Value)**
**NPV** is the difference between **PV of cash inflows** and **initial investment (PV of outflows)**.

**Formula:**
- **NPV = Σ [CFt/(1+r)^t] − Initial Investment**

### **Decision rule**
- **Accept** if **NPV > 0** (project adds value)
- **Reject** if **NPV < 0**

### **Payback period**
Payback measures the **time to recover initial investment**.

### **Comparison (exam table)**
| Method | Considers TVM? | Considers all cash flows? | Best for |
|---|---:|---:|---|
| **Payback** | No | No (ignores after payback) | liquidity focus |
| **NPV** | Yes | Yes | wealth maximisation |

Thus, **NPV is superior** for decision-making, while payback is a quick risk/liquidity measure.

Capital Budgeting Basics: Time Value of Money, NPV, IRR, Payback and Investment Decision Rules

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