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Lower the better applies to method of Capital budgeting

Lower the better applies to method of Capital budgeting

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

Lower the better applies to method of Capital budgeting

 Options:

A. npv
B. pay back period
C. irr
D. profitability index

The Correct Answer Is:

  • B. pay back period

The statement “Lower the better” typically applies to the payback period method of capital budgeting. In capital budgeting, companies evaluate and prioritize investment projects to determine which ones are most financially viable. Several methods are commonly used for this purpose, including Net Present Value (NPV), Payback Period, Internal Rate of Return (IRR), and Profitability Index.

Each of these methods has its own advantages and limitations, and they are used to assess different aspects of an investment project. Let’s explore why the answer is correct and why the other options are not:

1. Payback Period (Correct Answer – B):

The payback period is the time it takes for a project to recoup its initial investment. In this method, a shorter payback period is generally considered better because it implies that the investment will recover its costs more quickly.

A shorter payback period means reduced risk as it implies a faster return of capital. The “lower the better” concept is relevant in this case because a shorter payback period indicates a more efficient use of resources.

2. Net Present Value (NPV – Option A):

NPV is a method that considers the time value of money by discounting all future cash flows back to their present value. In NPV analysis, a higher value is better.

An investment with a positive NPV is typically considered attractive because it indicates that the project is expected to generate more cash inflows than its initial cost, resulting in a net gain. Therefore, NPV does not follow the “lower the better” principle; instead, it follows the “higher the better” principle.

3. Internal Rate of Return (IRR – Option C):

IRR is the discount rate at which the NPV of an investment becomes zero. The IRR method assumes that the cost of capital is the same as the IRR rate. In IRR analysis, a higher rate is generally more favorable, as it suggests that the project’s returns are greater than the cost of capital. So, IRR also does not adhere to the “lower the better” principle.

4. Profitability Index (Option D):

The Profitability Index (PI) is calculated by dividing the present value of cash inflows by the present value of cash outflows. A PI greater than 1 implies a positive NPV, which suggests that the investment is expected to generate more value than its initial cost. Like NPV, a higher PI is considered better, not lower, as it indicates a more favorable investment opportunity.

In summary, the “lower the better” principle is not applicable to most capital budgeting methods, including NPV, IRR, and Profitability Index. Instead, a “higher the better” principle is typically used for these methods.

The correct answer is the payback period (Option B) because a shorter payback period indicates a quicker recovery of the initial investment, making it more desirable from a risk management perspective. In contrast, the other methods aim for higher values to indicate more attractive investment opportunities.

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