Capital budgeting is a crucial decision that a business owner is required to make. This decision involves deciding which assets and products are more profitable to invest in and which markets to penetrate. Therefore, business organizations use different methods to assist them in making such decisions including: the net present value (NPV) method, the payback method and the internal rate of return (IRR) (Brealey et al., 2009). The NPV describes the difference between the between the current value of cash inflows and the current value of cash outflows within a specified period of time. The payback method helps the business owner to project how much it will cost them to develop a product and how much revenue the product is likely to generate once it is introduced in the market. The IRR is a calculation that is used to predict the profitability of an investment.
When comparing the payback method to the NPV method, the payback method has various disadvantages. For instance, the payback method does not consider the account inflation and the cost of capital. Although the purchasing power of money decreases over time the payback method equates the $1 invested with $1that will be generated in the future. Secondly, the payback method does not factor in any of the cash flows that are acquired beyond the stipulated time horizon, even though those cash flows may be significant. On the other hand, the NPV method is not reliable since the projections given by its assumptions may be false. For example, if one does not get the correct discount estimate correct, the calculations will be incorrect, and one will not notice it until the projections turn into losses. The IRR is a simple and easy method to use for calculating and allows the business owner to make comparisons between various projects – thus, providing business owners with a quick snapshot of which capital projections can generate the greatest potential cash flow (Bora, 2015). However, the con of this method is that it does not account for the project size of the business when making comparisons.
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References
Bora, B. (2015). Comparison between NPV and IRR. Int. Journal of Research in Finance & Marketing , vol.5, Issue 12. ISSN 2231-5985
Brealey, R.A., Myers, S.C. and Allen, F., (2009). Principles of Corporate Finance, 9th Edition, McGraw-Hill.
