Question

There are three methods of evaluating capital projects that are commonly utilized. What are these methods? Do they all depend on time value methods?

Answer 1

Companies use various methods to evaluate the capital projects.The major ones are:

1)Payback period:As the name suggests it calculates how long does it takes to get our primary/initial investment back.But the major drawback of this is that it does not consider time value of money as a factor.Say there are two projects where in the payback is one year(assumption).In this case, for the first project you get majority of the the return in the first 6 months itself.Whereas for the 2nd project you get it only in the latter half.Here even though the payback period is the same,you would choose 1st project over the 2nd.But payback period method does not help in choosing that.

2)Net Present Value Method(NPV):To overcome the drawback of payback method,we have Net Present Value Method.This method uses the discounted cash flow method which takes into account the time value of money.Also its calculated taking into account all the cash flows by deducting the cash outflows from cash inflows.If NPV>0,we accept the project.

3)Internal Rate of Return(IRR):This method also takes into account time value of money.This is also known as Yield on Method.Internal Rate of Return is the discount rate which makes the present value of the future/expected cash flows from the project to zero.So here the project with the highest rate of return can be chosen.In this way it helps to compare multiple projects.The one where IRR is greater than Cost of Capital will be chosen.