Evaluating Capital Investment Techniques- Net Present Value, Internal Rate of Return, and Payback Method

Evaluating Capital Investment Techniques- Net Present Value, Internal Rate of Return, and Payback Method

Net Present Value (NPV)

NPV falls under the discounted or time-adjusted capital investment techniques. It refers to a difference between future cash flow and initial investment based on the present value and discounted at a firm’s capital cost (Azeez, 2014). The technique is recognizant that cash flows at different periods differ in value, hence can only be expressed with respect to a common denominator (present value).

Merits of NPV include the explicit recognition of the changing value of money depending on time. Besides, the technique is a simple absolute measure of a project’s profitability. On the flip side, the demerits of NPV include its estimation of cash flows, which could change due to some uncountable circumstances. Besides, the technique ignores the advantage of creating options. Projects that seem undesirable under NPV may turn valuable if circumstances change in the future.

Internal Rate of Return (IRR)

IRR, just like NPV, is based on time-based money valuing. It is a technique that equates the NPV of a project to rates. Therefore, it is the compound rate a firm will receive if they invest in a project and receive certain cash flows annually (Azeez, 2014).

Merits of IRR include its recognition of the time value of money throughout a project’s life cycle. Also, the method is consistent with the overall goal of improving shareholders’ wealth. Disadvantages of IRR include lengthy and complicated calculations. The method may also provide conflicting results if projects under consideration are mutually exclusive.

Pay Back Method

The payback technique is a traditional capital budgeting method and perhaps the most popular capital budgeting technique. It simply refers to the period it takes a firm to recoup the initial outlay investment (Awomewe & Ogundele, 2008). A firm comes up with an acceptable payback period (PBP), and if the project’s PBP exceeds the period, it is rejected.

The advantage of PBP is that it is broadly used and easily understood. Besides, the method favors large projects with early cash flows. However, the project ignores a critical business aspect: the time value of money. Another demerit of PBP is the overemphasis on short-term profitability.

References

Awomewe, A. F., & Ogundele, O. O. (2008). The importance of the Payback method in Capital budgeting decisions.

Azeez, W. (2014). Capital Investment Appraisal in Retail Business Management: Sainsbury’s as a Case Study. SSRN Electronic Journal. https://doi.org/10.2139/

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Managers can choose from several analytical techniques to help them make capital investment decisions. Each technique has advantages and disadvantages.

Evaluating Capital Investment Techniques- Net Present Value, Internal Rate of Return, and Payback Method

Respond to the following in a minimum of 175 words:

Distinguish between the 3 capital investment techniques of (1) Net Present Value, (2) Internal Rate of Return, and (3) Payback Method.
Describe what you consider the top 2 advantages and 2 disadvantages of each technique and provide an example to support your top advantage of each method.