Capital budgeting is a quantitative method of evaluation of investments used by decision-makers to create a portfolio projects for the company (Tayler & Warren, 2018). There are several capital budgeting techniques, such net present value (NPV), internal rate of return (IRR), payback period, and discounted payback period (Tayler & Warren, 2018). This paper part of the capstone project focuses on the analysis of a potential investment in order to make a decision whether the project should be accepted using IRR and NPV. Moreover, the paper aims and discussing which of the two methods is more appropriate for the situation.
Selecting and Calculating
Project 1 was selected for evaluation out of three possible investment opportunities. The project was associated with a $17 million investment in equipment, which would depreciate on a straight-line basis to zero salvage value in five years. Other assumptions associate with the investment is weighted average cost of capital (WACC) of 5%, which was used as the minimal expected rate of return, and effective tax rate of 28%. The results of the calculations demonstrated that the IRR of the project was 5.1%, and NPV was $41,575. The calculations of the project’s cashflows are provided in Table 1 below.
Table 1. Project Cashflows
Implications of the Calculations
The NPV of the project was a positive value of $41,575. NPV is a commonly used appraisal technique that takes into consideration the time value of money. This approach provides a clear signal for investing or not investing in a project. It is calculated by adding all the discounted cash flows (Mclaney, 2017). If the value of NPV is positive, it is clear signal that the project is profitable after incurring the time value of money. If a project has positive profitability after deducting the time value of money, it should be accepted if no better options exist (Mclaney, 2017). The calculations demonstrated that the selected project will have positive profitability of $41,575 with WACC of 5%, which is enough to be accepted.
The IRR approach is another important metric that can be used to measure the profitability of a project. This metric is essentially a return rate (or WACC) that would make NPV of the project be equal to zero (Mclaney, 2017). According to the method, a decision-maker should accept a project of the IRR is higher than the current expected rate of return (WACC). In the situation with the investment described in Table 1, the IRR was 5.1%, which is above the expected minimum rate of return of 5%. Thus, according to the calculations, the investment opportunity should be accepted. However, before making the final decision, the investors should assess the accuracy of the cashflow forecast. The central problem here that the calculations allow a very small margin of error, as if the actual IRR is slightly lower than the estimated IRR, the project should be declined.
Selecting the Best Method
In the situation describe in this case, NPV is the preferred method of project evaluation due to one central benefits of the method. Both NPV and IRR approaches take into account the time value of money or the idea that a dollar today is worth more than a dollar tomorrow (Fool, 2015). This is crucial for assessing the investment decisions as money today is more valuable than money in the future (Merati & Alavi, 2017). However, NPV provides estimation of monetary benefit of the investment instead of giving the percentage value (Fool, 2015). In other words, NPV provides more valuable information and a clearer marker for the decision-makers to accept or decline the investment. IRR is more suitable for comparing investments with different caliber of initial investments (Fool, 2015). Since the proposed project s not compared to any other investment possibilities, the NPV approach is more preferable that IRR. However, since both approaches are based on the same date, it may be beneficial to use both methods to evaluate investment opportunities from different angles.
References
Fool, M. (2015) Advantages and disadvantages of Net Present Value method. Web.
Mclaney, E. (2017) Business finance: Theory & practice. (11th ed.). Pearson.
Merati, M., & Alavi, A. (2017). Assessment of industrial projects with expected monetary value approach using fuzzy multi-criteria decision making methods, case study: The project of construction of tile factory. International Journal of Scientific Management and Development, 5(3), 116-128.
Tayler, W. B., & Warren, C. S. (2018). Managerial Accounting. Cengage Learning.