Budgeting of capital investments is an important process that organizations use to determine the viability of an investment project. There are different methods that can be used for this process but we will look at three common methods; Payback period, Net Present Value (NPV) and the Internal Rate of Return (IRR) method.
The Payback period determines how long it will take for a project to recoup its initial investment. It is calculated by taking the total cost of the project and dividing it by the yearly income the investment is supposed to bring in. The shorter the number of years it will take to recoup the investment the better for the organization. The method is quite straightforward and is best when dealing with fairly small and simple projects. The main disadvantage of this method is it cannot be used effectively when dealing with huge and fairly complex projects ( Fabozzi & Peterson 2008).
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The Net Present Value method works by calculating the difference between the project cost and the cash flow generated from the project. The future cash flows used in the calculation are discounted to cover for uncertainties in the future that may negatively affect the cash flow. Independent projects are usually accepted when NPV is positive. It has an advantage as it can be used for mutually exclusive projects where the project with the highest NPV is preferred. Companies however prefer using percentages, as in IRR, rather than figures as is done in NPV ( Varshney & Maheshwari 2010).
The internal rate of return is usually defined as the discount rate that occurs when a project is break even, or when the NPV equals 0. Organizations will prefer projects where the IRR is higher than the cost of financing. The greater the difference between the financing cost and the IRR, the more attractive the project becomes. The method is quite direct when it comes to independent projects but it becomes a bit tricky when it comes to mutually-exclusive projects particularly because most of these projects have different initial costs of investment. This method is also ineffective for projects that exhibit a mix of positive and negative cash flows ( Varshney & Maheshwari 2010).
I believe that the NPV method is slightly better in comparison to the IRR method and the payback period. The payback period is too basic and only applicable for small investments. The NPV method beats the IRR method in a number of ways. First of all, the discount rate for some projects is not known thus NPV works better. Secondly, discount rates usually change especially for longer term projects but IRR does not account for changes in its calculations (Baker &English 2011). Lastly, NPV calculations allow for mixed cash flows accounting for them separately as opposed to IRR which is ineffective in this situation.
References
Baker H.K., English P. (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects. John Wiley & Sons .
Fabozzi F.J., Peterson P.P. (2008). Capital Budgeting: Theory and Practice. Wiley Publishers.
Varshney, R.L., Maheshwari K.L., (2010). Managerial Economics. 23 Daryaganj, New Delhi 110002: Sultan Chand & Sons.
