Question

Of the following techniques of capital budgeting, which one explicitly incorporates an estimate of an interest rate into the basic computation?

a. Payback method.
b. Average rate of return.
c. Discounted cash flows method.
d. Accounting book value method.

Answer 1

The discounted cash flows method explicitly incorporates an interest rate into its computations by discounting future cash flows to present value. Therefore, the correct option is C.

Step-by-step explanation:

Among the techniques of capital budgeting, the one that explicitly incorporates an estimate of an interest rate into the basic computation is the discounted cash flows method. This method involves discounting future cash flows back to their present value using a specific interest rate, which may include not only the opportunity cost of investing financial capital but also a risk premium if the investment appears particularly risky. The interest rate used in the discounted cash flows approach is critical because it determines the present value of the future cash flows and, ultimately, the decision about whether to undertake the investment.