Methods of Evaluating Capital Projects

Methods of Evaluating Capital Projects

Introduction

Capital budgeting techniques are used by the investors in order to ascertain the future prospects of a particular project. Different methods and techniques are used to assess the profitability of the budgets which will be carried out in future. Assessment is carried out in order to find out the future profitability of the project or investment and the expected rate of return (Bierman, 2012).

Capital budgeting decisions carries immense importance in the project sustainability carried out by any company. Cases have been reported where companies have been bankrupted or liquidated due to ineffective capital budgeting decisions they made at one particular time. Capital budgeting decisions are extremely important because on those decisions the future prospects of the company lies. Capital budgeting decisions provide a sense of direction and opportunity for future growth (Awomewe & Ogundele, 2008).

Capital budgeting is a process through which companies or investors evaluate whether a project is worthy enough to be carried out. Investors assess the timings and amount of the cash flows in the future and compare them with the predefined benchmark. It is important for the company to assess the impact of carrying out an investment decision on the financial health of the company. Any project before investment must be compared with alternatives so wise decision can be made (Awomewe & Ogundele, 2008).

Comparing Capital Project Evaluation Methods

Net Present Value

NPV (Net Present Value) is technique which represents the dynamic investment analysis with the help of discounted cash flows. The NPV principle is primarily based on the fact that a value of dollar today is worth more than the value of dollar tomorrow. The profitability of the investment is assessed by the cash flows it will generate in future and then discounting those cash flows. NPV rule states that if a project NPV is zero the return will be equivalent to the alternative investment. If the NPV is greater than zero, the return will be greater than alternative mode of investment and if it is less than zero the investment will not be recovered and capital will be depreciated (Rudolf, 2008).

NPV is obtained by subtracting the discounted cash inflows with the initial cash out flow in order to determine the net present value of the cash flows in today's currency value. Net present value accounts for all the cash flows incurring during the life of the project. The discount rate can be adjusted accordingly during different economic conditions in order to assess the true value of the project. If the discount rate is lower the NPV will be negative and if the discount rate is higher the NPV will be positive. The project with the highest NPV is selected because it as providing the net cash flows over and above the initial investment even after applying the discount rate (Akinbuli, 2011).

Internal Rate of Return

IRR (Internal Rate of Return) is a technique used to analyze the true interest earned over the life of the capital ...