MEMO
Subject: Capital Budgeting analysis
To analysis a capital investment project three widely use techniques are Net Present Value method, IRR and Payback period.
Net present value method considers time value of money while analyzing profitability of a project.
All cash inflows that are likely to occur during the lifetime of the project is discounted with the company's cost of capital to determine their present value and from this discounted present value of future inflows current cash outflow is deducted to find the net present value of the investment.
If the discounted present value of inflow is higher than the present value of outflow, NPV is positive and the project is acceptable and if NPV is negative, project is not acceptable. This method has advantage of applicability in case of mutually exclusive projects and it provides present value in absolute terms. But determination of appropriate discount rate is main problem associate with this method.
The other method of analyzing investment projects is Internal Rate of Return (IRR) method. This method also considers time value of money and attempt to find the rate of return the project is generating during its lifetime.
Here we find a discounting rate which equates present value of inflow with outflow or in other words which make present value of inflow equal to present outflow. The rate so determined is the rate of return which the project is expected to generate during its lifetime.
Now this rate of return is compared with the company's cost of capital to analysis the profitability of the project. If the rate of return is higher than cost of capital then the project is acceptable otherwise not.
Payback period method determines the time which is required by a project to recover its initial investment. If the period is less than the standard period then the project is acceptable otherwise not. This method has advantage of easy to use and simple to understand. Another benefit is it does not require cost of capital to make decision because it is often difficult to estimate exact cost of capital.
Major drawback of payback period method is it does not consider time value of money, which is an important factor when deciding about a capital expenditure. Another problem is cash flow occurs after payback periods are not taken into account in this method.