In capital evaluation a number of financial decision making options are used. The paper shall focus on the following capital investment decision making evaluation criteria Net Present Value, Profitability Index and the Internal Rate of Return. The paper shall discuss the definitions, the advantages and the disadvantages in each of the criterion for capital evaluation.
The Net Present Value (NPV) is the capital investment evaluation method that considers the final outcome after the cash outflows have been deducted from the cash inflows. In other words, in NPV method, all the costs and incomes are considered and the difference calculated. The NPV is the residue that is left after the outflows have been deducted from the inflows. The NPV must be positive for the project or investment being evaluated to be viable.
The Profitability Index (PI) is the ratio of inflows to the outflows. Inflows and outflows in this case are considered in their entirety. Profitability Index, therefore, is a ratio that seeks to show the number of times the inflows outweigh the outflows. Naturally, for a positive and viable project the PI has to be more than one.
The Internal Rate of Return (IRR) is a computation that is arrived at through the arbitrary calculation using NPV at lower and higher rates. The IRR is compared to the required rate of return. For purposes of investment decision making, the IRR has to be more than the required rate of return for a project to be considered viable.
All the three methods have their pros and cons in arriving at investment decisions. For the NPV it considers the time value of money and ensures that the decision arrived at is viable. This is because the project is acceptable only if the NPV is positive. To that extent, NPV ensures one settles for only viable options. In addition, NPV exhausts all the cash flows in the calculation and, therefore, saves the decision maker from making a poor choice based on uncalculated future cash flows. On the other hand, NPV is difficult to compute and does not take into consideration non-monetary returns and benefits of a project. In addition, the NPV method is based on predicted rates of returns which are mere estimates and hence do not reflect the real and actual occurrence in the near future.
The Profitability Index is a ratio of the inflows against the outflows. It takes into consideration all the inflows and outflows in a project and similarly takes consideration of the time value of money. It is easier to understand as it does not depend on any arbitrary set rate of return but rather considers to what extent the inflows exceed the outflows. Its disadvantages mainly resonate around its dependence on the predicted rate of return in discounting the cash inflows and outflows and the fact that it fails to illuminate the non-monetary rewards in the project options.
Finally, the IRR is more robust and applicable when the NPV is zero. The IRR goes further to illustrate the returns of projects as compared against the arbitrary set standard. In addition, IRR can be helpful in postulation of different scenarios possible as it shows the possible outcomes at different rates of capital. However, IRR equally relies on the NPV values and, therefore, carries all the loopholes in the NPV system. In addition, it is the most tedious method to use in calculation.
Works Cited
Banks, Erick. Finance: The Basics. New York: Routledge, 2010.
Dlabay, Les R and James L Burrow. Business Finance. New York: Cengage Learning, 2007.
