Skip to content

Lower the better applies to ___________ capital budgeting method.

Lower the better applies to ___________ capital budgeting method.

Looking for the answer to the question below related to Financial Management ? 

Lower the better applies to ___________ capital budgeting method.

 Options:

A. NPV
B. Payback period
C. IRR
D. Profitability Index

The Correct Answer Is:

  • B. Payback period

The correct answer is B. Payback period because “lower the better” is a relevant criterion for evaluating projects or investments using the payback period method. The payback period measures the time it takes for an investment to recover its initial cash outlay, and in this context, a shorter payback period is generally considered more favorable.

Let’s delve into the details of why Option B is the correct choice and why the other options (NPV, IRR, and Profitability Index) are not typically assessed with a “lower the better” perspective.

B. Payback period (Correct):

The payback period is a simple capital budgeting method that assesses how quickly an investment can recover its initial investment or cash outlay through the net cash inflows it generates. In the context of the payback period, “lower the better” is an appropriate criterion because a shorter payback period indicates a quicker return on investment.

Investors and businesses often prefer projects that can recover their initial costs rapidly, as it reduces risk and improves liquidity. Therefore, with the payback period, a lower (shorter) payback period is more favorable.

Now, let’s examine why the other options are not typically evaluated with a “lower the better” perspective:

A. NPV (Net Present Value) (Not typically evaluated as “lower the better”):

NPV measures the difference between the present value of cash inflows and the present value of cash outflows over the life of an investment. A positive NPV indicates that the project is expected to generate a profit, but the focus is on the magnitude of the positive value, not whether it’s lower or higher.

A higher positive NPV is generally more desirable as it represents a project that generates more value above the cost of capital. A “lower the better” approach does not apply to NPV.

C. IRR (Internal Rate of Return) (Not typically evaluated as “lower the better”):

The IRR is the discount rate at which the net present value of cash flows from an investment equals zero. The IRR represents the rate at which an investment breaks even, and it is not evaluated with a “lower the better” perspective. A higher IRR is generally more favorable because it indicates a higher rate of return on the investment, which is preferred by investors and businesses.

D. Profitability Index (Not typically evaluated as “lower the better”):

The Profitability Index (PI) is a ratio of the present value of cash inflows to the present value of cash outflows. A PI greater than 1 indicates a project that is expected to generate a positive return. While a higher PI is preferable, the Profitability Index is not typically evaluated as “lower the better.” Instead, it is assessed by whether it exceeds the threshold of 1 or some other predetermined value.

In summary, the “lower the better” criterion is relevant for the payback period method because a shorter payback period indicates a quicker recovery of the initial investment, which is generally considered more favorable.

However, this criterion does not apply to NPV, IRR, or the Profitability Index, as they are assessed differently, with a focus on higher positive values or rates of return rather than “lower the better.” Each of these methods serves its own purpose in capital budgeting, and the choice of method depends on the specific objectives and constraints of the investment decision.

Related Posts

Leave a Reply

Your email address will not be published. Required fields are marked *