There are different methods used in capital budgeting. They include the net present value, profitability index, internal rate of return and payback period. This research paper will evaluate the differences that exist between these methods basing the argument on the strengths and weaknesses of these methods.
The net present value method is used to determine whether a certain project should be invested or not. It is obtained by summing the present value of the future cashflows of a project. On the other hand, profitability compares the present value of the future cashflows to the initial capital outlay of a project in form of ratio. The difference between the two is that the net present value is an absolute measure whereas the profitability index is a relative measure. The net present value can be used to show whether a project should be undertaken or not. If the net present value is positive, then project should be undertaken but if negative, it should be dropped (Riahi-Belkaoui, 2001). On the other hand, the profitability index helps to rank various project such that it is possible to prioritize some project as compared to others. Whereas the profitability index can help rank projects, net present value tells whether a project should be undertaken or not.
The net present value just tells whether a project will generate positive profits and if so, the project should be undertaken. The internal rate of return goes a step further to show the rate of return that can be expected from a project. If there are several projects, internal rate of return becomes better since it can show the project that will generate the highest return hence should be considered first. The net present value cannot tell which project should be undertaken first.
Profitability index and internal rate of return are different in a way. The profitability index can only rank projects in their order of profitability. However, it does not show the return that should be expected from a project as is the case in the use of internal rate of return. Even though the profitability index will show the best project to invest in among several projects, it does not indicate the rate of return so that the managers can make a better decision. Internal rate of return is better in that even though a certain project may be the best in terms of profitability index, the managers may fail to invest in it if their expected rate of return from the investment is greater than the internal rate of return (Lasher, 2010).
Net present value does not show the time that it takes for the initial investment to be recovered from the cashflows of a project. The payback period will show the time that it will take for the initial invested capital to be recovered. A disadvantage of the payback period method is that it does not consider the time value of money. The worth of a shilling today is not the same as its worth in the future. However, the risk averse managers prefer payback period in that they are able to choose a project that will bring back the invested money within a short period which is not the case with net present value (Riahi-Belkaoui, 2001).
The profitability index and the payback period methods are able to rank projects so that the order in which the projects should be implemented is known. However, the profitability index is better in that it considers the risk factor and hence the time value of money is considered in the method. However, this method may not help managers who want to know the projects that will bring money within the shortest time possible (Lasher, 2010).
Internal rate of return will show the returns that are expected from a project hence it becomes easy to determine whether the rate is acceptable to the managers. However, it does not show the time of recovery of the invested funds. This differentiates it from the payback period method. However, for managers who consider the time value of money, internal rate of return is better in that it takes care of that.
Some of the budgeting techniques have similarities. Net present value, profitability index and internal rate of return take into consideration the time value of money. When making calculations in this case, the present value interest factor is used to find the present value of future cash flows. However, the payback period does not consider the time value of money. Profitability index, internal rate of return and payback period is useful when we have more than one project because it becomes possible to rank the project such that the best project can be chosen. However, the net present value is useful to tell whether investing in a project is profitable or not (Lasher, 2010).
References.
Lasher, W. R. (2010). Practical financial management. Mason, OH: Thomson South-Western cengage learning.
Riahi-Belkaoui, A. (2001). Evaluating capital projects. Westport, CT: Quorum Books.
