Methods for Evaluating Investment Projects
Although screening and preference decisions in capital budgeting differ in the way in which they set the criteria for acceptance of investment projects, they use the same techniques for evaluating the projects. One of the best known techniques is to find the internal rate of return of an investment. This is the rate of return on the investment over the life of the project. The internal rate of return is effectively the discount rate at which the cash inflows from the project would be the same as the cash outflows.
For example, if there is a certain capital outlay at the beginning of the project, and a few years later there will be cash inflows that are much greater than the initial outflow of funds, a large discount rate would be required to equate these inflows to the initial outflow. The internal rate of return of that project is, therefore, high. The project would be selected by the enterprise provided that this internal rate of return is greater than the predetermined minimum rate of return (using the screening method) or is greater than the internal rate of return of competing projects (using the preference method). The minimum rate of return determined as a standard for acceptance of capital projects is likely to be based on the company's cost of capital.
Using the internal rate of return works reasonably well if the project consists of an initial outlay followed later by cash inflows. However, many projects involve irregular cash flows in both directions, such as an initial outlay followed by some further cash outflows at a later date, and cash inflows that may vary greatly from one year to another.
To avoid some of the problems involved in using the internal rate of return, enterprises may often use another method of selecting capital investments which is to find the net present value of each project. This involves discounting the future cash inflows and outflows at a particular discount rate to arrive at the net present value of the project.
The discount rate would be determined according to the enterprise's required rate of return on projects, which in turn would be based on the enterprise's cost of capital. Where the present value of the future inflows exceeds that of the outflows, so the net present value of the project is positive, this may indicate the enterprise should go ahead with the project, as it satisfies the minimum requirements built into the selection of the discount rate. Where a preference decision is required, the net present value of the proposed project will be compared to that of the competing projects to arrive at the capital budgeting decision.
A further method that may be used is the payback method, which considers the amount of time required for the project to cover its original cost from subsequent cash inflows (the payback period). A maximum payback period could be selected as a standard for acceptance of projects. This method gives only a rough indication of the viability of a project as it does not directly assess the level of profitability of the project or the length of time over which the cash inflows will continue after the initial investment has been recovered.
It also does not take into account the time value of money as no discount rate is used. The payback method is also less useful if there are uneven cash outflows and inflows over the course of the project.