Three steps are involved in the evaluation of an investment:
- Estimation of cash flows
- Estimation of the required rate of return
- Application of a decision rule for making the choice.
You have understood the first two steps while studying earlier units. Thus our discussion in this chapter is confined to the third step. Specifically, we focus on the merits and demerits of various decision rules.
The capital investment decision rules may be referred to as capital budgeting techniques, or investment criteria. A sound appraisal technique should be used to measure the economic worth of an investment project. The essential property of a sound technique is that it should maximize the shareholders wealth.
The two most comprehensive measures of whether a project is profitable or unprofitable are the net present value (NPV) and internal rate of return (IRR).
- Net Present Value (NPV): For a project with one investment outlay, made initially, the net present value (NPV) is the present value of the future after-tax cash flows minus the investment outlay. Because the NPV is the amount by which the investor’s wealth increases as a result of the investment, the decision rule for the NPV is as – Invest if: NPV>0; Do not invest if NPV<O NPV
- Internal Rate of Return: The internal rate of return (IRR) is one of the most frequently used concepts in capital budgeting and in security analysis. The IRR definition is one that all analysts know by heart. For a project with one investment outlay, made initially, the IRR is the discount rate that makes the present value of the future after-tax cash flows equal that investment outlay. The decision rule for the IRR is to invest if the IRR exceeds the required rate of return for a project.
- Payback Period: The payback period is the number of years required to recover the original investment in a project. The payback is based on cash flows. If the payback period is being used (perhaps as a measure of liquidity), analysts should also use an NPV or IRR to ensure that their decisions also reflect the profitability of the projects being considered.
A number of capital budgeting techniques are in use in practice. They may be grouped in the following two categories:
Discounted Cash Flow (DCF) Criteria
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Profitability Index (PI)
Non Discounted Cash Flow Criteria
- Payback Period (PB)
- Accounting Rate of Return (ARR).