Once projects have been identified, management then begins the financial process of determining whether or not the project should be pursued. The three common capital budgeting decision tools are the payback period, net present value (NPV) method and the internal rate of return (IRR) method.
The payback period is the most basic and simple decision tool. With this method, you are basically determining how long it will take to pay back the initial investment that is required to undergo a project. In order to calculate this, you would take the total cost of the project and divide it by how much cash inflow you expect to receive each year; this will give you the total number of years or the payback period. For example, if you are considering buying a gas station that is selling for $100,000 and that gas station produces cash flows of $20,000 a year, the payback period is five years.
As you might surmise, the payback period is probably best served when dealing with small and simple investment projects. This simplicity should not be interpreted as ineffective, however. If the business is generating healthy levels of cash flow that allow a project to recoup its investment in a few short years, the payback period can be a highly effective and efficient way to evaluate a project. When dealing with mutually exclusive projects, the project with the shorter payback period should be selected.
Net Present Value (NPV)
The net present value decision tool is a more common and more effective process of evaluating a project. Perform a net present value calculation essentially requires calculating the difference between the project cost (cash outflows) and cash flows generated by that project (cash inflows). The NPV tool is effective because it uses discounted cash flow analysis, where future cash flows are discounted at a discount rate to compensate for the uncertainty of those future cash flows. The term "present value" in NPV refers to the fact that cash flows earned in the future are not worth as much as cash flows today. Discounting those future cash flows back to the present creates an apples to apples comparison between the cash flows. The difference provides you with the net present value.
The general rule of the NPV method is that independent projects are accepted when NPV is positive and rejected when NPV is negative. In the case of mutually exclusive projects, the project with the highest NPV should be accepted.
Internal Rate of Return (IRR)
The internal rate of return is a discount rate that is commonly used to determine how much of a return an investor can expect to realize from a particular project. Strictly defined, the internal rate of return is the discount rate that occurs when a project is break even, or when the NPV equals 0. Here, the decision rule is simple: choose the project where the IRR is higher than the cost of financing. In other words, if your cost of capital is 5%, you don't accept projects unless the IRR is greater than 5%. The greater the difference between the financing cost and the IRR, the more attractive the project becomes.
The IRR decision rule is straightforward when it comes to independent projects; however, the IRR rule in mutually-exclusive projects can be tricky. It's possible that two mutually exclusive projects can have conflicting IRRs and NPVs, meaning that one project has lower IRR but higher NPV than another project. These issues can arise when initial investments between two projects are not equal. Despite the issues with IRR, it is still a very useful metric utilized by businesses. Businesses often tend to value percentages more than numbers (i.e., an IRR of 30% versus an NPV of $1,000,000 intuitively sounds much more meaningful and effective), as percentages are more impactful in measuring investment success. Capital budgeting decision tools, like any other business formula, are certainly not perfect barometers, but IRR is a highly-effective concept that serves its purpose in the investment decision making process.
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