Capital Budgeting Evaluation Methods

capital budgetingWhen evaluating a project or long term investment of company, it is important to reach right decisions based on the capital budgeting methods. Analysts often use several important criteria to evaluate capital investments. The two most comprehensive measures of whether a project is profitable or unprofitable are the net present value (NPV) and internal rate of return (IRR). In addition to these, there are four other criteria that are frequently used: the payback period . The article gives instructions on each of the evaluation methods.

Understanding the Project Types

One of the key things in evaluating the project is to estimate the future cash flow of the projects, however, Several types of project interactions make the future cash flow analysis challenging. The following are some of these interactions:

  • Independent versus mutually exclusive projects: Independent projects are projects whose cash flows are independent of each other. Mutually exclusive projects compete directly with each other. For example, if Projects A and B are mutually exclusive, you can choose A or B, but you cannot choose both. Sometimes there are several mutually exclusive projects, and you can choose only one from the group.
  • Project sequencing. Many projects are sequenced through time, so that investing in a project creates the option to invest in future projects. For example, you might invest in a project today and then in one year invest in a second project if the financial results of the first project or new economic conditions are favorable. If the results of the first project or new economic conditions are not favorable, you do not invest in the second project.
  • Unlimited funds versus capital rationing. -An unlimited funds environment assumes that the company can raise the funds it wants for all profitable projects simply by paying the required rate of return. Capital rationing exists when the company has a fixed amount of funds to invest If the company has more profitable projects than it has funds for, it must allocate the funds to achieve the maximum shareholder value subject to the funding constraints.

Net Present Value (NPV)

For a project with one investment outlay, made initially, the net present value (NPV) is the present value of the future after-tax cash flows minus the investment outlay.

Because the NPV is the amount by which the investor's wealth increases as a result of the investment, the decision rule for the NPV is as follows:

  • Invest if: NPV>0;
  • Do not invest if NPV<O NPV

Internal Rate of Return

The internal rate of return (IRR) is one of the most frequently used concepts in capital budgeting and in security analysis. The IRR definition is one that all analysts know by heart. For a project with one investment outlay, made initially, the IRR is the discount rate that makes the present value of the future after-tax cash flows equal that investment outlay.

The decision rule for the IRR is to invest if the IRR exceeds the required rate of return for a project.

Payback Period

The payback period is the number of years required to recover the original investment in a project. The payback is based on cash flows. For example, if you invest $10 million in a project, how long will it be until you recover the full original investment?

Payback period methods is simple and easy to understand, however, it has many drawbacks. First, it is a measure of payback and not a measure of profitability. By itself the payback period would be a dangerous criterion for evaluating capital projects.

The payback period may also be used as an indicator of project liquidity. A project with a two-year payback may be more liquid than another project with a longer payback.

Because it is not economically sound, the payback period has no decision rule like that of the NPV or IRR. If the payback period is being used (perhaps as a measure of liquidity), analysts should also use an NPV or IRR to ensure that their decisions also reflect the profitability of the projects being considered.