
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.
Payback Period
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 mutuallyexclusive 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 highlyeffective concept that serves its purpose in the investment decision making process.
Capital Budgeting: The Capital Budgeting Process At Work
Payback Period
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 mutuallyexclusive 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 highlyeffective concept that serves its purpose in the investment decision making process.
Capital Budgeting: The Capital Budgeting Process At Work
Related Articles

Investing
An Introduction To Capital Budgeting
We look at three widely used valuation methods and figure out how companies justify spending. 
Small Business
Capital Budgeting: Which is Better, IRR or NPV?
Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense. 
Investing
Internal rate of return: An inside look
The internal rate of return can be used to measure an compare capital projects, stock buyback programs, and investments to determine which will yield the most favorable return. 
Investing
Private Equity on Steroids: How Debt Fuels Outsized Returns
Hot Air: Many private equity firms use a legal technique that can boost returns by 25% or more, Bloomberg says 
Financial Advisor
How to Compare Permanent Life Insurance Policies
Here's how you can use the internal rate of return to compare and purchase a permanent life insurance policy. 
Financial Advisor
A Guide on the RiskAdjusted Discount Rate
When a project or investment faces higher amounts of risk or uncertainty, it may be appropriate to utilize the riskadjusted discount rate. 
Personal Finance
10 Ways to Improve Cash Flow in Construction
Here's how improving cash flow in construction requires some sectorspecific strategies. 
Personal Finance
A project manager's qualifications and career path
Learn about a project manager's job, the qualifications necessary for the position, and the most common careers for these professionals. 
Small Business
Capital Budgeting
Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”