Capital budgeting is a decision-making tool used by analysts in the financial field in assessing whether or not a capital investment should be carried out in a particular project; from a financial point of view. An excellent financial analyst is supposed to have the recognition that the greater capital budgeting capacity is revealed through a sound procedure that carries out evaluation, comparison and selection between at least two investment alternatives or capital expenditure which gives out “satisfactory cash flows and rates of return” (Financial Modeling Guide, 2010, para 2). Various capital budgeting techniques are used in this regard and these include; the Net Present Value (NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR), Price Index (PI) and Discounted Pay Back (DPB). All these techniques are used to make decisions about whether or not to invest in a particular project. All these have their pros and cons and this is going to be the concern of this paper. After reviewing the literature concerning each of these tools, a conclusion is going to be presented concerning which tools are the most popular and correct to be applied by the analysts when planning to invest in a particular project(s) or business asset(s).
The NPV of a project or investment is described as “the difference between the present value of a project’s future cash flows and the present values of its costs” (Zackius-Shitu, N.d, p.5). The firms accept those projects that have a positive NPV and reject those with a negative value. Since NPV offers a direct dollar measure of “how much a capital project will increase the value of a firm, pursuing projects with zero NPV may seem an inefficient utilization of the firm’s resources since they do not add value to the firm” (Zackius-Shitu, N.d, p.5).
Where there is comparing of at least two investments by utilizing the net present value technique, a reasonable discount rate that indicates the risk(s) associated with each investment under consideration is supposed to be the one to be chosen. It would be sensible for an expert in financial analysis to evaluate different projects or investments at different “discount rates” and this is for the reason that each project or investment is associated with its own risks. However, a good analyst in this regard “would always keep in mind that the result of an NPV based capital budgeting assessment can only be as reliable as the discount rate that is chosen” (Financial Modeling Guide, 2010, para 3). In case the selected “discount rate” which is used in assessing the NPV is not practical, the decision made as to whether to accept or reject the project will thus, not be reliable.
In the same way as NPV, the IRR method as well utilizes cash flows and makes recognition of the “time value of money”. Even as the computation and understanding of the IRR are easy, this method has its weaknesses. The main weakness that is associated with this method is that it, time and again, offers rates of return that are unrealistic. This is illustrated in the Financial Modeling Guide (2010) by taking a situation in which an assumption is made where there is an assessment carried of financial attractiveness of an investment that has a “hurdle rate” of 10 percent and the IRR is calculated to be 30 percent (Financial Modeling Guide, 2010). It is pointed out that the direct conclusion that can be made by the analysts from the 30 percent IRR is that the project or investment is financially attractive and is supposed to be accepted with an immediate effect. However, this is not close to the reality, “as an IRR of 30 percent assumes that there is an opportunity to reinvest future cash flows at 30 percent, rather than an actual return of 30 percent” (Financial Modeling Guide, 2010 para 5). It is further pointed out that if proven, “historical business performance and general economic conditions indicate that a 30% return is an exceedingly high rate for future re-investments; there would be the reason for good financial analysts to suspect that an IRR of 30% is unrealistic” (Financial Modeling Guide, 2010, para 6). In simple terms, a 30 percent IRR can be taken to be too good to be a reality. It is concluded that; for this reason, unless the “calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject an investment” (Financial Modeling Guide, 2010, para 6).
An outstanding financial analyst is as well supposed to have the awareness that the IRR method may involve a larger number of problems than a “financial modeler” may predict. Another weakness of this method is that it may offer different rates of return. To illustrate this; an assumption is made about a situation where there are two discount rates (two IRRs) which make the PV of an investment equivalent to the initial investment. In such a situation, a financial analyst would make great efforts to make a choice between the two discount rates as being a “decision factor comparison with the cutoff rate” (Financial Modeling Guide, 2010, para 7).
However, in a real-life situation, the Internal Rate of Return method is taken to be a more well-liked and uncomplicated method as compared to the Net Present Value method used in the field of financial management and the process of decision making. It is mostly used by business managers who have no advanced level of financial knowledge.
In general terms, “to balance the trade-offs between the NPV and IRR methods, a good financial modeler would rely on both the NPV and the IRR when performing a capital budgeting assessment” (Financial Modeling Guide, 2010, para 7). In case the results obtained from returns evaluation by employing the IRR technique is an extremely high value; the main concern of the financial moderator is supposed to be whether that high rate is feasible to sustain by considering the past yardsticks as well as the existing ones and also by looking at the business opportunities ahead, to find out whether an opportunity to carry out reinvestment of cash flows at such an impressive rate is there. In case it doesn’t exist, a competent financial analyst would engage in the revaluation of “the financial attractiveness of the investment by the NPV method, using a discount rate that is well researched and proven to be realistic and viable” (Financial Modeling Guide, 2010, para 8). )
The Modified Internal Rate of Return (MIRR) method is similar to the IRR method because it considers the discount rate that equates the present value of cash outflows for a particular project or investment with the present value of the terminal value of cash inflows from the same investment or project. The method “converts the operating cash flows to a future cash value at the end of the project’s life compounded at the cost of capital” (Zackius-Shitu, N.d, p. 6). Under the rule of MIRR, the recommendation for the project acceptance occurs where the MIRR is higher than the cost of capital and this confirms the attractiveness of the project.
Moreover, Discounted Payback (DPB) method gives an answer to the question of rational investment of “how long it will take to realize the capital invested in terms of its discounted cash flows” (Zackius-Shitu, N.d, p.7). To some extent similar to the ordinary payback period, this method (DPB) discounts “the future cash flows by the cost of capital which tells the management how long it takes a project to reach an NPV of zero” (Zackius-Shitu, N.d, p.7). However, this method addresses the weakness of the ordinary payback period method by putting the time value of money into consideration.
The last technique to be considered here is the Profitability Index (PI). After a firm carrying an evaluation of a variety of assumptions and scenarios, “it may not be out of place to attempt to understand the efficiency of its investment by comparing the PV of the projected cash flows with the initial outflows” (Zackius-Shitu, N.d, p. 7). Because the Price Index is the ratio of inflows to outflows, the PI may be considered as being a comparison between the benefits of investment and the costs (inflows and outflows). The consideration made by the PI for the benefits and costs is an indication that PI puts into consideration such factors as “time value of money, wealth maximization, the riskiness of cash flows and its efficiency” (Zackius-Shitu, N.d, p.7).
Financial analysts in various organizations utilize a combination of capital budgeting tools like the ones that have been discussed for them to be able to make capital budgeting decisions. However, based on the literature that has been looked at, it seems that some of these tools are favored over others. For example, Peterson & Fabozzi (2002) links the popularity of IRR to the fact that “it is a measure of yield and easy to understand” (Peterson & Fabozzi, 2002, p.108). However, due to some weakness that the IRR has that may result in the selection of a wrong project, Peterson & Fabozzi (2002) point out in this regard that NPV may soon substitute the IRR as being a popular technique. In comparison it was reported by Parrino, Moles & Kidwell (2011) that by the year 1999, about 75 percent of the organizations that were surveyed were using the NPV method frequently were earlier on, in 1981, only about 17 percent of the firms used this method. Similarly, about 75.5 percent of the firms were using the IRR method compared to 65.3 percent in 1981 and this serves as a confirmation that the firms use a combination of tools. Supporting this, Kierulff (2008) concludes that the NPV and the IRR methods are the preferred tools used in making capital budgeting decisions. However, this researcher favor MIRR more, making an affirmation that “MIRR is a more accurate measure of the attractiveness of an investment alternative because attractiveness depends not only on the return on the investment itself but also on the return expected from cash flows it generates” (Kierulff, 2008, p. 325)
Financial Modeling Guide. (2010). Capital budgeting and the pros and cons of IRR and NPV. financialmodelingguide.com. Web.
Kierulff, H., (2008). MIRR: A better measure. Business Horizons. 51 (1), 321-329.
Parrino, R., Moles, P. & Kidwell, D.S. (2011). Fundamentals of Cooperate Finance. London: Wiley & Sons Ltd.
Peterson, P.P & Fabozzi, F. J. (2002). Capital budgeting: Theory and practice. New York: Wiley & Sons Ltd
Zackius-Shitu, K. (N.d). AGOA: Who benefits? Scrbd.com. Web.