Critical examination of evaluation techniques14/03/2023 1 By indiafreenotes
While capital budgeting evaluation techniques provide valuable information for decision-making, they are not perfect and have their limitations. Here are some critical examinations of these techniques:
Discounted Cash Flow (DCF) Techniques:
- Assumptions: DCF techniques rely heavily on assumptions about future cash flows, which can be difficult to predict accurately. Small changes in assumptions can significantly affect the results of the analysis.
- Cost of Capital: Estimating the cost of capital is a critical component of DCF analysis. However, the cost of capital is not always easy to estimate, and different methods may yield different results.
- Complexity: DCF techniques can be complex and time-consuming, requiring significant financial modeling and analysis.
Non-Discounted Cash Flow Techniques:
- Time Value of Money: Non-discounted cash flow techniques do not take into account the time value of money. As a result, they may not accurately reflect the true profitability of an investment.
- Ignoring future cash flows: These techniques only consider cash flows in the initial years of an investment and ignore cash flows in later years, which may lead to an incomplete evaluation of an investment.
- Decision-making: Non-discounted cash flow techniques do not provide a clear framework for decision-making, making it difficult to compare different investment options.
- Ignores future cash flows: Payback period only considers the time it takes to recover the initial investment and ignores future cash flows, which may lead to an incomplete evaluation of an investment.
- Arbitrary Cut-off: The payback period uses an arbitrary cut-off point, which may not be appropriate for all investments. This method does not consider the opportunity cost of the investment or the time value of money.
- Risk Assessment: Payback period does not take into account the risk associated with an investment, which may affect the profitability of the investment.
Accounting Rate of Return:
- Ignores the time value of money: The accounting rate of return does not take into account the time value of money and assumes that cash flows are equal over time.
- Subjectivity: The calculation of accounting profits is subjective and can vary from one company to another.
- Cost of Capital: The accounting rate of return does not consider the cost of capital, which may affect the profitability of the investment.
In conclusion, while capital budgeting evaluation techniques are valuable tools for decision-making, it is essential to recognize their limitations and carefully consider their results. A combination of techniques, including sensitivity analysis, scenario analysis, and risk analysis, can provide a more comprehensive evaluation of an investment.