discussion

in 250 words

Capital budgeting involves choosing projects that add value to the  firm. The net present value (NPV), internal rate of return (IRR) and  payback period methods are the most common approaches to project  selection. At its core, capital budgeting is measuring an accounting of  costs versus benefits. In a way, all business decisions are a series of  capital budgeting decisions. Get it wrong, and you can destroy a  company.

The capital budgeting tools help financial managers decide on the  desirability of the projects. In the real world, however, managers  sometimes will make decisions that don't necessarily agree with the  decision rules of the payback period, NPV or IRR methods.

For example, consider the two mutually exclusive projects below.

Investments

Cost

Cash Flow 1

Cash Flow 2

Project A

$ 50 

$ - 

$ 100 

Project B

$ 50 

$ 50 

$ 25 

According to the payback period, project B should be selected.  Although both projects cost the same, project B has a payback period of  one period, while project A will payback in roughly 1.5 periods. 

Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20. 

This example illustrates the limitations of the payback period  method. Even though the payback period method points to project B, the  NPV method points to project A since it has more than twice the NPV  value to that of project B. Yet the manager may choose project A. Why?

It may be that the project stakeholder is requesting a quicker return in cash.

For this discussion, create an example problem where two (or more)  methods contradict each other. What would be the "appropriate" choice  (which project would you choose)? In what cases would you not choose the  "best" choice?