EVALUATION OF CAPITAL INVESTMENT ALTERNATIVES
Capital investment proposals are evaluated based on following financial tools.
Methods used include:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Payback Period and Discounted Payback Period
- Profitability Index (PI)
INTERNAL RATE OF RETURN
The IRR is the discount rate at which the PV of future benefits exactly equals the PV of the investment (in other words, a zero NPV)
- All the relevant cash flows discussed in the calculation of the NPV are also relevant here however the rate at which we are discounting the cash flows is unknown
- The only way (even for a computer) is to substitute different discount rates into the equation until the resultant NPV comes to zero (this is known as trial and error)
NPV VS IRR
If the IRR is greater than the WACC, the project should be accepted.
- This decision will always be compatible with the decision obtained from NPV analysis because a positive NPV automatically means that the IRR is greater than the WACC
- A difficulty arises when comparing two mutually exclusive projects
- There is an important and close relationship between NPV and IRR. The NPV is greater than zero if and only if the IRR is greater than the discount rate. This relationship implies that if a single proposed capital investment is considered in isolation, both NPV and IRR will provide the same answer to the question of whether or not the investment should be undertaken. However, NPV and IRR need not provide the same answer if projects that require different investments are compared. In conclusion, NPV and IRR need not rank projects equivalently, if the projects differ in size.
- The project with the highest NPV may not have the highest IRR
- Under such circumstances, the NPV is always the criteria to use
PAY BACK PERIOD
A simple approach to capital budgeting that is designed to tell you how many years it will take to recover the initial investment.
- It is often used by financial managers as one of a set of investment screens, because it gives the manager an intuitive sense of the project’s risk.
- The calculation can be performed without considering the time value of money or by considering time value (discounted payback).
PROFITABILITY INDEX (PI)
Another measure that can help in ranking the projects when several are involved is the profitability index (PI)
- Uses exactly the same figures as are needed for the NPV and is calculated as the ratio of the PV of net cash benefits to the PV of the investment.
- A ratio greater than 1.0 will always result when the NPV is positive
- When the NPV is zero, the PI will be exactly 1.0
All three measurements (NPV, IRR and PI) will result in the same decision for a particular investment