Net Present Value
The Net Present Value is used in estimating the potential value of every project by applying the discounted cash flow valuation that requires an estimation of the size and time of all cash flows that increases from the project (Ehrhardt & Brigham, 2016). However, NPV is affected greatly by the discounting rate. Therefore, making a selection on the proper rate that is sometimes known as the hurdle rate is essential during decision making. Moreover, this should make a reflection on the riskiness of the investment because it is typically measured by the unpredictability of cash flows. Therefore, it must take the financing mix into consideration.
The discount rates may be estimated by the managers through the use of CAMP models to provide an estimation of the appropriate discount rate for every project. On the other hand, the weighted average cost may be applicable while making a reflection on the selected financial mix. That is the standard practice in choosing the discount rate for a given project is by making good use of the weighted average cost (WACC) in the whole company (Mukherjee, T., & Hingorani, 1999). However, the higher rate of discount may be suitable especially when the risk of the project is greater than the risk in the entire company.
The major advantage of the NPV is that it acts as a direct measure of the expected increase in the value of the company. Hence, it is the best method for capital budgeting. Other advantages include; NPV does not show whether there will be an increase in the investment with the value of the firm. NPV makes a consideration of the time value of money and all cash flows. Similarly, NPV takes into account the future risk of the cash flows in particular through the cost of capital. On the other hand, the major disadvantage of NPV is that it is not able to factor in the size of the project. For instance, an NPV of $ 1,000 is good for any project that costs $ 1,000 and not so perfect for any project costing $ 1,000,000. Other advantages include; NPV needs an estimation of the cost of capital for its calculation, and it is expressed in dollars, not as a percentage form.
Internal Rate of Return (IRR)
The internal rate of return as a discounting rate provides the NPV of zero (0), and it is common while measuring investment efficiencies. Therefore, it will provide similar decisions as the net present value for none- mutual and exclusive projects especially in a free setting where there is an occurrence of undesirable cash flow at the beginning of the project by all desirable cash flows. Still for the unique mutual projects, the decision rule for considering the project with the highest IRR, that is always used, a manager may make a selection on a project with a lower net present value. However, the main advantage of the internal rate of return is that it provide a profitability measurement as a percentage, and this indicates the performance of every dollar that is invested.
It also gives information on the margin of safety that the NPV does not provide. Therefore, managers can tell the estimated return of the actual project that can fall in a percentage form before the project becomes uneconomic (indicates a negative NPV). Additionally, IRR can tell whether there is an increase in investment in respect to the value of the firm. It also makes a consideration to all cash flows of the project, and the time value of money invested. Lastly, it considers the future risks of the cash flows through the cost capital decision rule.
The biggest problem with IRR is that it is always misunderstood when reporting the actual profitability of investment for the year. The internal rate of return requires an estimation of the cost of capital for decision making. Similarly, IRR may not provide a value-maximizing decision, especially when applied in comparing mutually exclusive projects. It is not applicable in situations where the sign of the cash flows of a plan changes more than once during the life of the project. Lastly, IRR may not provide value-maximizing decisions when applied in choosing the projects especially when capital rationing exists.
Profitability index
Profitability index is used in ranking the projects of a company since it allows one to quantify the amount of value that is created for every unit of investment. PI tells whether the increase in investment increases the value of the firm. Similarly, it considers the projected cash flow for the period and the time value of money. It also factors in the future risks of cash flows through the cost of capital. Moreover, it is essential for the selection and ranking of projects at the time when capital is rationed. Concerning the disadvantages, PI needs an estimation of the cost of capital to calculate this index. Additionally, it may not provide accurate decisions when used in comparing mutually exclusive projects.
Payback period
It is the period that is needed for the return on investment to repay the total amount of the original investment (Ehrhardt, M., & Brigham, 2016). Therefore, it measures the duration the sum invested takes to repay itself. Shorter payback periods are better than longer payback periods. It has some serious disadvantages and qualifications in its use because it does not account for the time value of money, opportunity cost, financing, and risk. Therefore, it does not have concrete decision criteria to show whether an investment is increasing as the value of the company increase. It also ignores cash flows that are beyond payback periods, time value of money, and future cash flows. Regarding the advantages of the payback period, it is easy to calculate, it offers some relevant information concerning risks on the investment, and it provide a crude measure of liquidity.
The NPV, MIRR, and IRR assist companies to identify whether to accept or reject a project. However, these techniques have different assumptions even though; they have similar objectives (Mukherjee & Hingorani, 1999). However, NPV is the best amongst them because it is based on the cash flow method. Therefore, the cost of capital of the company is the assumed reinvestment rate of the net present value. It is the IRR as a discount rate that makes the net present value to be zero (0). Therefore, it is an assumption of IRR that cash flow should be ploughed at the rate of return of the project. The modified internal rate of return (MIRR) assumes that the cash inflows of the company are compounded at the cost of capital for the company, and the discounted rate is determined to make the present value of the terminal value to be the same to the present value of the cash outflows.
Since NPV is discounting the future cash flows at the cost of capital for the investor, it represents the value of the project more accurately. Similarly, it assumes that the cash flows are reinvested at the cost of capital. However, the assumption is appropriate as long as there can be some repayment of the finance in stages to reduce the cost of equity or interest. According to the MIRR, a project is described in a simple form as a percentage rate of return. In contrary, IRR does not make an assumption that there can be a productive reinvestment of the cash flows in the plan at the computed rate of return. However, they are assumed to be reinvested at any particular rate like the bank interest rate.
According to the mathematical calculation of the NPV, the cash flow of the project can be reinvested at the cost of capital. The IRR makes an assumption on reinvestment at IRR. Since there can be some replacement of the cash flows of additional capital costing (r), then good reinvestment assumption rate will be the capital cost. Thus, the appropriate capital decision method is NPV. Both NPV and IRR involve compound interest, and there should be reinvestment rates. However, NPV assumes that there is a reinvestment at the cost of capital while IRR assumes that there is reinvestment at IRR. Additionally, since MIRR is the modified version of IRR, it will assume reinvestment at the cost of capital.
NPV is the best method for evaluating the projects because it employs more realistic rate of reinvestment assumptions (Ehrhardt, Brigham & Houston, 1999). Therefore, it provides a better indicator of profitability and the wealth of shareholders. Mathematically, it will also give the correct decisions regardless of whether the project undergoes some abnormal cash flows or some indifferences I the size of the projects and timing of the cash flows.
The most commonly used budgeting methods are the internal rate of return, payback period, and the net present value. The IRR is used in comparing capital investment against other investments. For instance, the IRR is higher than the hurdle rate, then the project is viable. Therefore, IRR is simple to understand, and this is why it is most commonly used technique.
NPV determines the cash that will flow as a result of the investment, and it will compare it against money that will flow out to make the investment. Since the flow can occur over time, and the investment will pay off later, the present and future value of money will be taken into account. This is because both inflation and money earned in future will be worth less in the present dollar than the same figure would be today. Therefore, NPV is most frequently used because it computes all inflows and outflows over time while considering inflation and the rate of foreign exchange.
The payback period will remind the managers the duration a project will recover the investment in a project. For instance, the payback can be one (1) if the project will take one year to make back the investment from the revenues of a new product (Mukherjee & Hingorani, 2000). It is frequently used by managers because it favors cyclical goods that usually make the bulk of their cash rather than those products that build momentum and produce a fistful of cash flows over a long period.
References
Ehrhardt, M., & Brigham, E. (2016). Corporate Finance: A Focused Approach (6th ed.). Cengage Learning.
Ehrhardt, M., Brigham, E., & Houston, J. (1999). Fundamentals of Financial Management (2nd ed.). The Dryden Press.
Mukherjee, T., & Hingorani, V. (1999). Capital Rationing Decisions of Fortune 500 Firms. A Survey. Financial Practice and Education, 9(1).
Mukherjee, T., & Hingorani, V. (2000). Capital Rating Decisions of Fortune 500 Firms. Part II. Financial Practice and Education, 9(1).
