Among financial analysts there are several criterions used to make an investment decision regarding capital budgeting. The two most effective and important ones are Net Present Value(NPV) and Internal Rate of Return(IRR), some other criterions are used such as payback period, discounted payback period, Profitability Index(PI). Every analyst must understand the logic these criterions were based on and when they should be used as well as their weaknesses and limitations!.
Net Present Value(NPV): NPV is the present value of future after tax cashflows minus the initial investment
lets take a simple example to clear things out,
Assume we have ABC corporation that is looking to make a new investment to expand its share in the market, the investment’s cost is $40 million and is expected to generate $18 million for the next 5 years. The NPV for the investment in a market with a required rate of return of 7% will be :
NPV = (40) + 18 /(1+ 0.07) + 18 / (1+0.07)^2 + 18 / (1+0.07)^3 + 18 / (1 + 0.07)^4 + 18 / (1 + 0.07)^5 = $33.8 million
We can also compute is using the BA II Plus Professional by using the CF formula
The NPV is based on the question of ” by how much of dollar amount will this new investment increase the investor’s wealth?” so
* NPV > 0 ( accept the project)
* NPV < 0 ( reject the project)
based on that if you are comparing between mutually exclusive investments the one with the highest NPV value is the one to be taken.
Internal Rate of Return(IRR): IRR is the discount rate that makes the future cashflows of an investment equal to the initial investment, it can also be defined as the discount rate that makes NPV of an investment equal to zero.
As you can see this formula is quite similar to the NPV formula except that the discount rate here is replaced with the IRR.
There are few ways to find out the IRR value, first the trial and error and second using a financial calculator(I wont show how to calculate the IRR using the trial and error since its a long process and the goal of this article is to give a broad insight on capital budgeting).
If the IRR > r then accept the investment
IRR < r then reject the investment
for our ABC corporation example, the IRR using the financial calculator is 34.9% which is higher than our 7% discount rate, the investment will be accepted
NOTE : A single project will have the same conclusion using any of the 2 criterions but in the case of mutually exclusive projects conflicts may arise, in that case we should always take NPV as our base in making our conclusion, because of the reinvestment assumption! NPV assumes that we will reinvest our cashflows using the discount rate which makes the NPV more realistic.
Profitability Index(PI): Profitability index is the investment’s future cashflows divided by its initial investment
You can see that PI formula is related to the NPV, PI is the ratio of PV of future cashflows related to the initial investment where NPV is the PV of future cashflows minus the initial investment, so there’s no way there will ever be a conflict in conclusions between PI and NPV
- PI > 1 accept the investment
- PI < 1 reject the investment
For our ABC corporation example, PI index will be:
PI = 73.8/40 = 1.8
so we will accept the project
for mutually exclusive projects, the project with the highest PI will be the one to be taken.
PI is expressed as the value you are receiving for every unit of currency invested in the investment, Profitability index is known with that name in corporations but is also known as “benefit-cost ratio” in governmental organizations and NGOs.