Techniques for analyzing capital budgeting have changed a lot in due course. With different techniques, many analysts believe that techniques that consider the time value of money are more useful. Methods, like payback period, which is old, have a disadvantage of not using the time valuably and which at the end will fall. The older methods will be replaced by the newer and better methods. There are different capital budgeting techniques that investors use and there is no specific technique that every investor would be using. So it is the choice of the investors to select which method he wants to. However, investors do not rely on one method and therefore uses a combination of the techniques that have been discussed in this paper.
For analyzing a capital budgeting proposal the method of payback is simple and straight forward. However, this technique has some weaknesses as well. One of the weaknesses of payback period is that time value of money is considered in this technique. The techniques analyses the cash flows instead of the time of their occurrence. Moreover, this technique does not use interest rate. This is one of the reasons why investors use other techniques as well while making project appraisal decision.
Discounted payback period:
Discounted payback period is another technique that is used to analyze and overcome the problems of the payback period. This technique analyses the time period that the investment would take to recover using its cash flows that are discounted (Bodie, Kane, and Marcus, 2004). Using the discounted payback period, the future cash flows are discounted to calculate their present value and then they are accumulated till the initial investment is recovered. The discounted payback period will have a higher value in comparison to payback period because the cash flows will be discounted with the present value.
Although discounted payback period is used to overcome the weaknesses of the payback period. However the weakness with this method is that the time value of the money is not considered in this technique. The other weakness is that discounted payback period does not consider debt or equity that the management would undertake in order to commence or start. Moreover, the impact of inflation is not considered in this technique.
Net present value:
A mathematical tool, Net Present Value (NPV), is a method which uses discounting process. Net present value (NPV) is defined as the future cash flows that are discounted by the discount rate and then the initial investment is deducted. NPV is one of the most used methods and project appraisal and capital budgeting technique that has been used by investors. However one of the problems with this technique is that at times calculating the forecasted and future cash flows is difficult (Brealey, Myers, Allen, & Mohanty, 2007). Moreover, while forecasting the future cash flows, assumptions have to be used and this can influence the final result and analysis. Projects that have a net present value of more than 0 are accepted and others are rejected. And the higher NVP should be accepted if there is any consideration. When the investment is made in the in a project by company with positive NPV, the company raises the share holder’s wealth and company’s value. This will surely increase the market value, the economic value for the firm.
Internal rate of return: (IRR)
The other technique used to analyse the project feasibility is the internal rate of return. This technique can be defined as the rate of return at which the net present value of future cash flows of the project are 0. The IRR method is actually the most commonly and widely used method for estimating the proposal of capital budgeting. And this is because this method is easy to understand. One of the strengths of using IRR is that the results of IRR can be easily compared with the returns that other investments are yielding such as bonds, t-bills and others. If the internal return rate is greater than the project’s minimum return rate, there would be tendency for the acceptance of the project (Gibson, 2012).
Which method is better the NPV or IRR?
NPV is better than IRR. The NVP is better for at least two reasons:
- Re-investment of the cash flows: one of the reasons why NPV is a better technique is that the cash flows of the project are assumed to be reinvested in order to earn hurdle rate. The other limitation of using IRR is that the future cash flows are considered to be reinvested (Gitman, 2003).
- For the IRR, there are numerous solutions: For the IRR, it is possible to have more than one solution of the matter. If the cash flow experience the sign change (such as, negative cash flows in the second year, positive cash flows in the first year, etc), the IRR method will have more than one solution.
In such situations, IRR method is not used to analyse and evaluate the project as there is no single value of IRR that makes the project superior from the other. However NPV does not have this issue.
Modified internal rate of return:
This method is to overcome the two deficiencies of IRR method. The person who is conducting the analysis can choose the rate of whatever he or she wants in order to investigate the cash flows for the reminder of the project’s life (Gibson, 2012).
For example, if the method of the hurdle rate is chosen by an analyst to use for the purpose of reinvestment, the MIRR technique calculates the present value of cash out flows and the future value of cash inflows (to the end of project’s life), and then in the next step it is solved in order to find the discount rate at which the present value of the cost is equal the future value. Several problems that have been identified in different capital budgeting techniques can be solved through MIRR:
- Analysts and investors can select whether to reinvest the cash flows at a reasonable rate or not.
- There is only a single technique that can solve the issue or give the solution.
Bodie, Z., Kane, A., and Marcus, A. (2004). Essentials of Investments, 5th ed. London, McGraw-Hill Irwin.
Brealey, R., Myers, S., Allen, F., & Mohanty, P. (2007). Principles of corporate finance. New York: McGraw-Hill.
Gibson, C. H. (2012). Financial reporting & analysis: Using financial accounting information. South-Western Pub.
Gitman, L. (2003). Principles of Managerial Finance. Boston: Addison-Wesley Publishing.