Capital Budgeting and Investment Evaluation Methods

There are a number of investment evaluation techniques that are used to evaluate various projects for purposes of making investment decisions. Net Present Value and Internal Rate of Return are two of investment evaluation methods that are popularly used in making investment decisions. IRR is a capital budgeting technique that is used to calculate IRR; the value calculated is compared with a rate that is cut off with a purpose of deciding which project to select (Pogue, 2004).

On the other hand, Net present value is a capital budgeting technique that is popularly used in making decisions related to investment. In most cases, when it comes to international investment decisions a company faces a situation where it has to decide on which project to invest in, especially in cases where there are two alternative projects which can be undertaken. In order to arrive at the right project, the management of the company in question should use different capital budgeting techniques. In most cases, financial managers face a dilemma in regards to the capital budgeting technique to use between NPV and IRR for the purposes of project appraisal.

There are circumstances when IRR or NPV may be best used in evaluating/ appraising projects. When it comes to IRR, it is best used when evaluating single project ; given that if it is used to evaluate multiple projects, it may give misleading results that may in their turn result into the wrong choices made by the finance managers. On the other hand, Net present value as a technique of capital budgeting is best used in cases where multiple projects are being evaluated because it gives accurate results that can help in making the right choices of projects which should be undertaken (Grier & Nagalingam, 2000).

In order to arrive at the best technique to be used between the two techniques, one should be aware of the advantages as well as disadvantages of using any of the two project appraisal techniques in making investment decisions. To start with, IRR has a number of merits and demerits. One of the merits of IRR is that it takes into account the concept of value of money with time unlike other capital budgeting techniques, making it one of the best methods of evaluating investments since it will give the actual values of returns expected from the project (Khan, 1993).

Secondly, in this method all cash flows from the project are treated equally. IRR as technique of capital budgeting has a number of disadvantages; first, the method is not easy to understand. Secondly, the method makes assumptions that are unrealistic. Finally, the method is not useful when it comes to comparison of projects that are mutually exclusive.

When it comes to usage of NPV in determining the cost of capital, the method has a number of merits and demerits. The first merit of NPV is that it takes into account the concept of value of money overtime when appraising various projects. Secondly, the method takes into account both after and before cash flows that will be realized in the project (Madura, 2011). On the other hand, the method gives risk as well as profitability of the project high priority unlike other methods of project appraisal.

Finally, the method is very vital as it plays a major role in maximizing the value of the company in question. Despite NPV having a number of merits, this capital budgeting technique has a number of demerits. First, the method cannot help in arriving at the right decision, especially in cases where the amounts of funds in projects that are mutually exclusive, are not the same (Bruce, 2003). Secondly, it is usually difficult to calculate the most appropriate discount rate to use in appraising the projects in question.

In conclusion, NPV stands out to be the best method of appraising international projects in comparison to IRR.

References

Bruce J. F, (2003). Investment Performance Measurement. New York: Wiley. Print.

Grier C. I.; Nagalingam, S. V. (2000). CIM justification and optimization. London: Taylor & Francis. pp. 36. Print.

Khan, M.Y. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill Higher Education. Print.

Madura, J. (2011). International financial management (11th ed.). Mason, OH: South-Western Cengage Learning. Print.

Pogue, M.(2004). Investment Appraisal: A New Approach. Managerial Auditing Journal.Vol. 19 No. 4.