Question

Describe the use of internal rate of return (IRR), net present value (NPV), and the payback method in evaluating project cash flows.

Answer 1

Solution

For an effective capital budgeting decision, following tools are highly useful,

Internal Rate of Return (IRR):

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. The formula and calculation used to determine this figure follows,
However, because of the nature of the formula, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software.
The higher a project's internal rate of return, the more desirable it is to undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects on a relatively even basis. Assuming the costs of investment are equal among the various projects, the project with the highest IRR would probably be considered the best and be undertaken first.
One popular use of IRR is comparing the profitability of establishing new operations with that of expanding existing ones. For example, an energy company may use IRR in deciding whether to open a new power plant or to renovate and expand a previously existing one. While both projects are likely to add value to the company, it is likely that one will be the more logical decision as prescribed by IRR.
IRR is also useful for corporations in evaluating stock buyback programs. Clearly, if a company allocates a substantial amount to a stock buyback, the analysis must show that the company's own stock is a better investment (has a higher IRR) than any other use of the funds for other capital projects, or higher than any acquisition candidate at current market prices.

Net Present Value (NPV):

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project. The following formula is used to calculate NPV,
A positive net present value indicates that the projected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss.
Net present value (NPV) is the calculation used to find today’s value of a future stream of payments. It accounts for the time value of money and can be used to compare investment alternatives that are similar. The NPV relies on a discount rate of return that may be derived from the cost of the capital required to make the investment, and any project or investment with a negative NPV should be avoided. An important drawback of using an NPV analysis is that it makes assumptions about future events that may not be reliable.

Payback Period:

The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a breakeven point. The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments.
The concept of the payback period is generally used in financial and capital budgeting. But it has also been used to determine the cost savings of energy efficiency technology.
The payback period is the cost of the investment divided by the annual cash flow. The shorter the payback, the more desirable the investment. Conversely, the longer the payback, the less desirable it is.
Payback periods are useful in financial and capital budgeting, although it has applications in other industries. It can be used by homeowners and businesses to calculate the return on the energy efficient technologies such as solar panels and insulation, as well as maintenance and upgrades.