The process through which the companies authorize the spending of capital on the long-term projects is known as the Capital budgeting. Capital projects require careful evaluation due to the limited availability of capital. There are many different techniques for capital budgeting but the most significant ones are the NPV and the IRR. The Net Present Value (NPV) is the method that determines the project worthiness by taking into consideration the devaluation of the money with time. Internal Rate of Return is that rate which is determined by the investor on a particular risk to forecast a profit (Arnold & Nixon et al., 2011).
I would personally use the NPV method as it is the most accurate method for budgeting; it can clearly indicate whether a project is worth investing in or not. As compared to the other methods like payback period and IRR, it is more accurate considering the time value of money. In this technique, the discounted cash flows are used to analyze the NPV; it takes into consideration both the variables of time and risk. If the result of analysis is positive, the project should be invested in but if it is negative, the project must not continue. The biggest drawback of the IRR method is that it only uses a single discount rate while evaluating all the investment (Roy, 2011). So, IRR is only applicable for those projects that have a common discount rate.
In another scenario, the NPV works better; when the project consists of a mixture of negative and positive cash flows, the IRR becomes ineffective. NPV on the other hand has the ability to handle more than one discount rate without any issue and discount each cash flow separately. Further, when the discount rate is unknown, the IRR has almost no value as this method requires comparing the IRR with the discount rate (Roy, 2011). In the other hand, if the discount rate is unknown, the NPV can easily work; the project is considered to be financially attractive if the NPV is greater than zero.
References
Arnold, T., Nixon, T., Baker, H. K. & English, P. (2011). Alternative methods of evaluating capital investments. Capital Budgeting Valuation: Financial Analysis For Today's Investment Projects, pp. 79--94.
Roy, D. (2011). Net present value versus internal rate of return: a review in search of the resolution of the debate. EDITORIAL BOARD, 42 (1), pp. 31--40.
