Capital budgeting Essay Example | Topics and Well Written Essays - 500 words

Capital budgeting - Essay Example In addition, NPV approach provides a clear indication on how the profits will be obtained, unlike IRR and payback approaches. Therefore, the NPV is the most useful tool in project valuation (Arthur, 2014). Of the three techniques (NPV, IRR, and payback period, the least useful tool to use is the IRR, because discount rate has an inverse relationship with NPV. When NPV continues to increase, the anticipated future cash flows become less valuable and hence making IRR least useful tool to use in project valuation. On the other hand, payback approach is the second least useful tool to use after IRR. The Payback period indicate how long the cash flow obtained from the project will recover the initial capital outlay. In addition, the payback period fails to indicate the amount of cash flow to be generated from the project. However, it is the simplest method of calculating project forecast (Arthur, 2014). The answer would not be the same because a negative NPV will be obtained when cost of capital increases from 14% to 25%. It means that as the cost of the capital increase the return obtained from the project decreases significantly up to a negative (Peterson & Fabozzi,2002). Such decrease makes the project un-profitable and, therefore, it is advisable for the EEC not to invest when cost of capital increases to 25%. If EEC did not save an even cash flow of $500,000 per year, the answer would be the same.The least amount of investment that would make this investment attractive to EEC is $100,000. From the above scenario, the EEC would be willing to pay the supplier $2000, 000. The president of EEC should be aware that if the cost of capital increases as discussed above, the underlying effect is a negative NPV. It means that the project will be no longer profitable to the company (Arthur, 2014). If the expected savings are less than $500,000 per annum, it will be difficult for the ECC to pay its supplier a capital of $2000, 000, and