In capital budgeting, multiple approaches can be used in project evaluation. Each of the methods has its distinct pros and cons. The most commonly used capital budgeting techniques include the Internal Rate of Return (IRR) and the Present Net Value (NPV).
Present Net Value (NPV)
NPV is a popular method used in comparing the profitability of various projects. It is usually based on the idea that “dollars received in the future are worth less than dollars in the bank today.” Therefore, to assess the profitability of a given project, future expected cash flows are usually discounted to determine their present values. The primary advantage of the method is that it is easy to use and interpret. By discounting the future cash flows, the stakeholders can, with a lot of ease, how much a project will be profitable to a firm. However, the method has its weaknesses. First, the technique involves guesswork, especially about the future cash flows and a firm’s cost of capital. Secondly, the net present value technique is inapplicable when comparing projects with differing investment amounts. Besides, the method tends to be challenging when making a comparison of projects with different lifespans.
Internal Rate of Return (IRR)
Also known as the economic rate of return, IRR uses percentages to estimate the profitability of potential investments. Usually, the method excludes outside factors such as inflation and capital cost when examining profitability. Like NPV, the technique has its pros and cons. To begin with, IRR takes into account the time value of money, thus giving each cashflow under consideration or evaluation of equal weight. Secondly, like NPV, it is simple to use and interpret. Also, the hurdle rate or cost of capital, usually a subjective figure, is not required here, thus eliminating the need for guesswork. However, the technique has various limitations that can result in wrong evaluations and assessments of projects. First, the method ignores the future costs. It also ignores the reinvestment rates.
NPV vs. IRR
Depending on the needs and goals of the projects, both methods can be used. However, NPV, as compared to IRR, is often considered preferable as it can handle multiple discounting rates, unlike IRR.