Question

Referencing textbook readings, lecture material, and current business resources explain key metrics of capital budgeting. Which metric(s) do you find more (less) important? Why?

Also, discuss the difference between leveraged and unleveraged NPV and IRR metrics. What is the purpose of calculating two types of NPV and IRR

Answer 1

By metrics it is meant to denote the performance indicators. Capital budgeting is all about allocation of capital to the most economically feasible projects to derive maximum profit at minimum cost. Atleast that is the target and objective. The performance indicators are as follows:

1. NPV: In this method, cash flows over the years are discounted by the cost of capital to their present value. The difference between the present values of cash flows and the initial outlay is called the net present value. A positive value represents a viable project. This metric is very realistic as it considers the time value of money which most other metrics such as payback period and ARR ignore.
2. IRR: The internal rate of return is the discount rate at which the NPV of all cash flows from a particular project equals zero. It uses similar calculations like the NPV metric. IRR can't be derived analytically and is usually derived using trial and error method or using spreadsheet softwares like excel or using financial calculators. The higher is the IRR, the more desirable is the project.
3. Profitability index: This is again derived from the NPV formula. The present value of projects is summed up and is divided by the initial outlay of the project. If the outcome is more than one, the project is considered desirable otherwise not.
4. ARR: The accounting rate of return metric is used for quick calculation of potential profitability especially when multiple projects are involved in an investment. It is calculated by dividing the average profit by the initial outlay. However, its major drawback is overlooking the impact of time value of money which makes it potential future estimates of profitability less worthy.
5. Payback period: This method doesn't calculates profitability in direct sense which makes it quite unusual compared to rest of the other metrics. Also since it doesn't specifically measure profitability, its recommendations are not entirely accurate. Another major flaw is lack of recognition to time value of money. This method calculates the length of time required to earn back the amount invested or achieve the break even point. The ones with lowest payback periods are considered the most desirable projects.

Among these five metrics, the most important is the NPV method followed by IRR and PI as they take into account time value of money and use the cost of capital of the firm to evaluate the projects. The least important is payback period method because of its multiple flaws discussed above.

Leveraged and unleveraged NPV and IRR are calculated to show the difference between unlevered FCF and levered FCF. Unlevered FCF is what firm has before paying off its financial obligations which include interest and taxes. Levered FCF is what remains after payment of these obligations. This difference is important as they show how much cash remains after payment of debt obligations.

Therefore the NPV and IRR calculated on the basis of levered and unlevered cash flows will also show similar differences. The purpose is to identify the difference in profitability between two types of cash flows and firm's actual financial health.