QUESTION 2 (50 MARKS)

In Capital Budgeting Techniques, some investment decisions involve choosing among independent projects, where accepting one project does not necessarily preclude accepting another unrelated project. However, managers typically have limited funds to invest and, therefore, must prioritize their investment resources (capital rationing). To prioritize independent projects, we cannot simply compare the Net Present Values, which are stated as absolute dollar values. This makes comparing projects of different sizes difficult. Although the Internal Rate of Return is a relative measure of performance, it assumes that the cash flows will be reinvested to earn the same IRR, a notion which is unlikely to be true for independent projects. Managers should prioritize capital investment projects based on a factor called the profitability index (PI).

REQUIRED: Carefully answer the following questions within their context. MARKS

(2.1) There are various Capital Budgeting Techniques (CBTs) that a company may use to evaluate its capita projects. Briefly explain how each of the following CBTs is calculated and what inferences can be drawn from its answers:

a) Net Preent Value

b) Accounting Rate of Rate

c) Internal Rate of Return

d) Profitability Index

e) Pay Back Period 30

(2.2.) Given your answers in (2.1.), when is it appropriate to apply each of the six CBTs? In your discussion, give two advantages and two disadvantages of each, and also state which one is considered more superior to all of them and why.