Introduction
Investment appraisal or capital budgeting is essentially a finance terminology for process of making a decision whether to undertake a given investment project or not. Therefore, it is a process that is used by the firms to determine whether or not a given investment is worthwhile. Frequently companies will have a number of opportunities and they should measure the potential of these opportunities so as to compare and choose only one or a few of them. It is therefore the responsibility of the organization’s management to analyze the potential projects and then chose the project(s) that look promising.
One of the main goals of the capital budgeting investments is actually to increase firm’s value to its shareholders. Various formal techniques are used in investment appraisal and they include Profitability Index (PI), Net Present Value (NPV), Internal Rate of Return (IRR), Payback period, among others. For that reason, the focus of this research paper is to explore these techniques where it contrasts and compares them. In addition, the paper discusses how firms use each technique in decisions involving capital budgeting.
Net Present VALUE (NPV)
This is also called Net Present Worth (NPW). This technique combines 2 concepts of value. For one, it determines the amount of cash that will flow in when an investment is undertaken and then compares that contrary to cash, which will flow out so as to make an investment. Thus, NPV is the sum of present values of individual cash flows of similar entity (Lasher 2011). In fact, this is the main tool in the analysis of discounted cash flow.
Additionally, NPV is the standard method for utilizing time value of money to appraise the long term projects. This technique is well-thought-out a sophiscated capital budgeting technique since it gives explicit consideration to TVM. NPV is calculated using the following formula
NPV compares today’s dollar value to the future value. A project is accepted if its NPV is zero or positive and rejected when NPV is negative. In the case of 2 or more projects that are exclusive and have positive NPVs, the one having highest NPV is normally accepted.
Strengths and weaknesses of NPV
NPV capital budgeting technique shares its strengths with IRR and Payback period technique. One of the strengths of this technique is that it tells if an investment is going to increase the value of the firm just like the mentioned two. In addition, it considers TVM, all cash flows, and risk of the future cash flows through cost of capital.
However, to calculate NPV one needs to estimate of cost of capital. Moreover, NPV is not expressed as a percentage as it is expressed in dollars hence this distinguishes it from the other techniques. Compared to IRR, NPV technique is less commonly used since it is viewed as inherently complex as well as requiring assumptions at every stage.
Internal Rate of Return (IRR)
This is a technique that is normally used to measure the investment efficiency. It is defined as a discount rate, which gives a NPV of zero. This technique is probably the most extensively utilized sophiscated capital budgeting technique. For non-mutually exclusive projects, this technique will result in a similar decision as NPV method in unconstrained environment in usual cases where negative cash flow takes place at the inception of a project followed by cash flows that are all positive.
In most genuine cases, firms should accept all the independent projects whose IRR is higher than hurdle rate. Nonetheless, for the mutually exclusive projects, decision rule of choosing a project with highest IRR may select a project that has a lower NPV. Conversely, if cash flow signs change more than one time, several IRRs may exist. IRR equation mostly cannot be solved systematically but only through iterations (Peterson and Fabozzi 2002) . A project whose IRR is greater than cost of capital is generally accepted while it is rejected if its IRR is less than cost of capital.
Strengths and weaknesses of IRR
As stated above, IRR and NPV have similar advantages. First, this technique uses the cash flows instead of earnings hence it accounts for all of them. In addition, IRR accounts for time value of money. This technique is also important as it tells if a certain investment will increase the value of a firm when it is accepted. Finally, IRR technique when used to select projects considers future cash flows risk (Lasher 2011).
However, IRR as a capital budgeting technique needs an estimate of cost of capital so as to make an informed decision. Additionally, IRR cannot be utilized in situations where project’s cash flows sign change more than once in the life of a project. Last but not least, in the case of capital rationing, this technique may fail to give a value-maximizing decision.
Payback Period
Payback period is actually the time amount that is required for a given firm to recover the initial investment it undertook, as calculated from the cash inflows. It is the duty of the management to determine the maximum payback period that is acceptable in a firm. The technique in most cases is used in evaluating the proposed investments. In case of annuity, this technique is calculated by dividing first investment by annual cash inflow. For mixed stream of the cash inflows, annual cash inflows should be accumulated up to the time when the first investment is recovered.
Albeit popular, this technique is normally seen as an unsophiscated capital budgeting technique, as it fails to explicitly consider time value of money (TVM). A project is accepted if payback period is actually less than maximum payback period that is accepted in a firm (Peterson and Fabozzi 2002). On the other hand, a project is rejected if payback period is essentially greater than maximum payback period that is accepted in a firm.
Strengths and weaknesses of payback period
One of its advantages is that it is simple to compute compared to the other techniques. Moreover, it provides a crude liquidity measure. Payback period is also advantageous since it provides information on risk of an investment undertaken, which is mostly not the case in other techniques.
Compared to the other three techniques, this technique is considered the weakest. This is because under it, there is no a concrete decision criteria to determine whether a given investment increases the value of a firm (Lasher 2011). Besides, the technique ignores the cash flows beyond payback period, future cash flows risk, and time value of money.
Profitability Index (PI)
This is the other capital budgeting technique. It is an index, which tries to pinpoint relationship between the benefits and costs of a project that is proposed. Therefore, profitability index is used to evaluate whether to advance an investment or a project. If it is greater than one, an investment or a project is considered profitable. Nonetheless, if it is less than one, an investment or a project is rejected.
Profitability Index is calculated using the following formula
PI = PV of Future Cash Flows/ Initial Investment
It is worth noting that PI is a variation of NPV. Generally, it is greater than one in case of a positive NPV whereas it is below one when NPV is negative. Therefore, it differs from NPV in that by it being a ratio, it actually ignores scale of investment and fails to provide an indication of size of actual cash flows.
Strengths and weaknesses of profitability Index
PI has the same strengths as NPV and IRR as mentioned above. Just like the two, PI tells whether a given investment raises the value of the firm. It also considers future cash flows risk, time value of money, and project’s cash flows. In addition, PI is suitable in both ranking and selecting the projects when the capital is rationed (Peterson and Fabozzi 2002).
One of its weaknesses is that it might fail to give accurate decision when it is used to compare projects that are mutually exclusive. Last but not least, it needs an estimate of cost of capital in its calculation.
References
Lasher, W. R. (2011). Practical financial management (6th ed.). Mason, OH: South-Western College Pub.
Peterson, D. P., & Fabozzi, F. J. (2002). Capital budgeting: Theory and practice. New York, NY: Wiley.
