When comparing two mutually exclusive proposals using both the net present value method and the internal rate of return method, you will find cases where one project is preferable to the other using one method, and the reverse is true using the other method. It is important to understand how and why this happens. The result is obtained because the two projects will have differing cash flows in different periods. Therefore, the compounding effect of the discount rate and the time value of money will produce different results.
The NPV at 15 percent discount rate is $849.68. The IRR is 23.5 percent.
The project returns $9,000 total and an undiscounted breakeven in 2 years.
The NPV at 15 percent discount rate is $918.71. The IRR is 22 percent.
The project returns $9,750 total and a break-even in 2 years and 4 months.
Which project is a better investment?
This example shows how similar cash flows in different periods will affect your decision-making process. Thus reliance on any one method, without understanding how it works may result in a distorted decision-making process.
Some people prefer the NPV method as superior to the IRR, because the IRR method implies reinvestment rates that will differ depending on the cash flow stream for each investment proposal under consideration. With the NPV method, however, the implied reinvestment rate, namely the required rate of return or hurdle rate, is the same for each proposal. In essence, this reinvestment rate presents the minimum return on opportunities available to you. You must employ judgment in evaluating what each model generates as a decision. Factors other than the rate of return may alter the choice of one proposal or the other. For instance: long term tax planning may favor one cash flow projection over the other in order to optimize long-term tax liabilities. Therefore, evaluate the expected cash flows and their timing.
Capital budgeting in the ongoing system of planning, evaluation, and execution of the business is itself a process. It starts with a determination of where you are, then where you want to be, then how you intend to get there. Even if you do not institute capital budgeting as an ongoing process, simply going through the exercise of setting up a process is a valuable endeavor of self-examination.
It gets people to think through how prudent investments in capital-intensive projects may help the business grow, diversify, or replace existing plant and equipment. Capital budgeting is a four-step process of (1) proposal solicitation or generation, (2) evaluation, (3) implementation, and (4) follow-up. In the evaluation step, various alternative proposals have various related returns associated with the investment. With this expected return is a probable risk of loss of all or part of the invested funds. In any endeavor, the decision must be based on balancing the return against the associated risk. The problem, of course, is that no certainty, even in the estimates of risk and return, exists. In order to minimize the risk, you should consider the method by which estimates, projections, and other numbers are generated.
You should be cautious when only one solution is proposed because there is seldom a problem without several possible solutions. When preparing a capital budgeting plan, develop contingency plans and scenarios after asking many what-if questions. As part of your contingency planning, do not put your head in the sand. Consider the dark side of the project: “What if it goes sour?” For such a proposition, you should be ready for bailout as a planned withdrawal; you should not be forced into mindless panic if a project faces immediate failure.
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