Net Present Value (NPV) and Internal Rate of Return: Two of the most comprehensive measures of evaluating strengths and limitations of capital investments.

When making capital investment decisions, it is always about deciding what makes the most sense from the cost-effectiveness point of view. Since capital budgeting plays a vital role in maximizing shareholders’ value, it comes as a no surprise that the economic theory has developed a number of rather sophisticated tools to help with the analysis of firms’ financial decisions.

Capital Budgeting Assumptions

Evaluation of firms’ capital investment projects is based on a number of basic principles. First, all decisions are based on the firm’s cash flows; however, not from the accounting point of view that might consider, for example, net income. Instead, the analysis focuses only on cash outflows and inflows. In addition, intangibles are frequently ignored unless they can generate hard cash, which is often not the case.

Furthermore, accurate and detailed timing of the cash flows is crucial to the capital project analysis. The process demands that analysts devote considerable attention to pinpointing when exactly, and if, cash flows may occur.

Thirdly, analysis of cash flows is based on opportunity costs. This means that an analyst must ask herself what cash flows would occur if the company proceeded with the investment, as well as how operations would be affected if it did not. While talking about costs, note that all cash flows are analyzed on an after-tax basis. To fully appreciate all the costs involved in a capital projects, taxes must be reflected in the subsequent cash streams.

Finally, note that during the evaluation process of capital projects, financing costs are ignored. At first glance, this might not appear as a fiscally prudent approach. However, remember that cash flows are analyzed on an after-tax basis and discounted at the required rate of return, which already reflects financing costs. So, if analysts also added financing costs to the equation, double-counting would occur, thus resulting in a distorted analysis. Even if a firm finances the project with either debt or equity, those costs are ignored on the face value because they are already captured in the discount rate.

Net Present Value

For projects involving an initial cash outflow, the project’s net present value (NPV) is the present value of the project's future after-tax cash flows less the initial investment. Note that the NPV formula only appears complex, but any good financial calculator will simplify the exercise with a few easy steps and carefully chosen inputs.

Since the net present value of investments represents the amount by which the project will financially benefit, or not, the investor or firm, the NPV rules are fairly simple:

• If NPV is greater than zero (positive) – invest;
• If NPV is less than zero (negative) – don’t invest;

The resulting reasoning is also simple. If NPV is positive and the end-result is wealth-increasing, investing in a project makes economic sense. The opposite is true if a proposed investment’s NPV is negative.

Internal Rate of Return

The internal rate of return (IRR) is perhaps one of the most frequently utilized methods of capital investment analysis. IRR is defined as the rate that discounts future after-tax cash flows to present value, less the initial cash outflow put into the investment. As was the case with calculating NPV, IRR is also rather difficult to solve algebraically, which is why it is computed with the help of financial calculators.

IRR decision-making rules state that:

• If IRR is greater than the required rate of return – invest;
• If IRR is less than the required rate of return – don’t invest;

Resolving Conflicting NPV and IRR

When a company’s executives evaluate independent conventional projects, at least they don’t have to worry about conflicts between NPV and IRR (e.g. NPV may be positive, but IRR of one project might be higher than the other’s required rate of return). However, when evaluating two or more mutually exclusive projects, the decision-making process becomes more complex.

For example, what is a manager to do when Project X has larger NPV than Project Y, but when Project Y has higher IRR than Project X? And, why would a discrepancy occur in the first place? To answer the latter question, the discrepancy between NPVs and IRRs of mutually exclusive projects is owed to dissimilar cash flow streams. And when the manager finds himself in this kind of a “pickle,” he should deem the project superior based on the higher NPV ranking.

Importance of Capital Budgeting Methods

Both NPV and IRR, along with other capital budgeting methods not discussed in this short overview (payback period calculations, average accounting rate of return, or profitability index), represent essential tools of trade for corporate managers. However, these methods also offer value to “outsiders,” such as institutional analysts.

Since a firm’s capital investment decisions have significant impact on the firm’s financial obligations, evaluating NPVs of capital projects is directly related to stock prices. If the firm manages its projects and financial obligations prudently, its stock price is likely to appreciate. However, if fiscally irresponsible decisions are made, the firm’s stock price is likely to suffer, along with its reputation and status as a public company.

(Source: Capital Budgeting by John D. Stowe and Jacques R. Gagné, CFA Institute, 2006)