Capital Budgeting Applications and Pitfalls

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This section will explain the pitfalls of the concepts of NPV and IRR. The application of such concepts can be difficult. This chapter will let you know about the difficulties faced by the application of these concepts. This will help you to overcome the problems which are generally committed by the companies.

As we know there are four rates frequently used in finance.

  • The IRR (Internal rate of return)
  • Expected rate of return
  • Cost of capital
  • Hurdle rate

Let’s discuss them briefly-

About IRR

It is a metric used to measure the effectiveness of probable investments. IRR can be said as a discount rate which turns the net present value equals to zero. The higher IRR is the more appropriate is to agree to the project. IRR is very popular in calculating the profitability of any project, but it should not use alone as it can be ambiguous sometimes.As compared to the other rates, IRR is dissimilar from them. One should be careful while calculating IRR as the calculation necessitates predictable cash flow which is quite challenging to determine.

Expected rate of return

It is calculated using the chances of occurrence and the outcomes. Expected return means the profit or loss which an investor faces by investing.The management must be smart enough to take the decisions on predictable degree of return. The expected rates should be exceeding the capital’s cost.

About WACC (weighted average cost of capital)

It is a type of return which can be earned by investing the same money into various investment which is of same risk. It can be ascertained by the market and gives awareness to the investors about the risk. Capital’s cost is determined by required degrees of yield of the project. It is controlled by the demand and supply in the economy for the resources.

Hurdle rate

Every company expects to earn a return from the investment which it makes. Hurdle rate can be said as the minimum rate that a company expects to earn when it invests in a project. If a company wishes to decide if a particular project should be accepted or not, the IRR must be the same or exceed the aforesaid rate.

We can say that the returns of projects are challenging to determine. Many companies use incorrect rate of return, they are based on expectations. Because of these hurdle rates are kept high from the capital’s cost.

Solve now!

Q1. Can hurdle rate is compared to project’s IRR (internal rate of return)?

Q2. Can a project’s capital cost is compared to hurdle rate in a market which is perfect?

 

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