Started with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.
The process in which a business determines whether projects such as building a new plant or investingin a long-term process are worth pursuing.
Basic steps of capital Budgeting
- Estimate the cash flows in the project
- Assess the riskiness of the cash flows.
- Determine the appropriate discount rate.
- Find the PV of the expected cash flows.
- Accept the project if PV of inflows > costs. IRR>Hurdle Rate and/or payback < policy.
Net Present Value of each project
- Net present value is a calculation that compares the present value (PV) of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return (also called minimum rate of return). Net Present Value (NPV) analysis is the process of taking a current investment and projecting the future net income from this investment.
- When NPV greater than zero indicates that an investment will be profitable when all of the above factors are considered.
- When NPV of less than zero indicates that an investment will not be profitable when all factors are considered. When several investments are considered, the alternative with the highest, positive NPV is the most profitable.
Suppose the company lacks the capital to undertake both projects. Which of the two projects then should the company select?
- The NPV of both project A and B have positive result. If the FIRMEX is not financially restricted it can invest in both projects. if we value the NPV of both these projects we can see that both project A and B has positive value which shows that both projects are successful. Which also mean that choosing any project will maximize the capital (wealth) of the firm.
- If the companies capital is not sufficient to invest in both projects, the management can invest in project B where the minimum investment and higher net present value. The payback of project A shows that the company can get their investment in one year of time but the project B takes longer time of two years. If payback taken into consideration the FIRMEX should invest in project A.
- The Internal Rate of Return (IRR) is a capital budgeting method used by firms to decide whether they should make long-term investments. The internal rate of return (IRR) or IRR for short is that discount rate which forces the NPV of a project to equal zero .IRR, is a measure of your investment performance, and is expressed as percent return per year .
- Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.
- We can think of IRR as the rate of growth a projectis expected to generate. While the actual rate of return thata given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.
IRR (The Internal Rate Of Return)
The IRR is the return rate which can be earned on the invested capital, i.e. the yield on the investment. A project is a good investment proposition if its IRR is greater than the rate of interest that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). The IRR should include an appropriate risk premium.
Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cash flows.
In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company.
The NPV is expressed in monetary terms. For example pounds and dollars. But IRR is true interest rate yield expected from an investment. If the IRR is higher the firm will earn more from the investment. Therefore, FIRMEX should select the project 'A' according to the IRR. Because, IRR for project A is higher than the IRR for project B.
- An advantage of the IRR method is that it considers the Time Value of Money and is therefore more exact and realistic than Accounting Rate of Return (ARR).
- It fails to recognize the varying size of investment in competing projects and their respective dollar profitability's.
- In limited cases, where there are multiple reversals in the cash-flow streams, the project could yield more than one internal rate of return.
Do the IRR results confirm those obtained from the NPV analysis in terms of which project adds greater value to the firm?
- The result shows that the project B showing greater firm when considering NPV in other hand project A is not showing greater value than project B.But in the other hand IRR result shows the project A should be given priority over project B.
- Therefore the IRR result do not confirm the result obtained from the NPV results.
References and bibliography
- Accounting for non-accountants:a manual for managers and students-by Graham Molt-6th Edition 2006
- Accounting In a Business-by Aidan Berry and Robin Jarvis, 2006
- Investment appraisal & Financing decision-third edition-by Stephen Lumby-3rd Edition 1988
- Capital Budgeting Financial appraisal of investment project-by Don Dayananda,Richard Irons,,Steve Harisson,John Herbohn,Patric Rowland-1st Edition 2002
- Analysing the companies & valuing shares,how to make right investment decision,Michael cahill,2003