Some Important Considerations in Capital Budgeting
Although a capital budget template is extremely useful in assisting management with selecting between two investment projects, there are some important factors that need to be considered:
Project relationship: If the projects are independent, the cash flows of Project A are not affected if Project B is selected and vice versa. In this case, the project with the positive NPV is selected. If the projects are mutually exclusive, selecting Project A may adversely impact Project B. In this case, the project with the largest NPV should be selected.
Using NPV or IRR: In independent projects, the NPV and IRR yield the same result, either rejecting or undertaking a project. In mutually exclusive projects, the NPV and IRR are usually conflicting. This is because the project sizes may vary or the timing of cash flows may be different. The IRR should be preferred over NPV only when the project can sustain a high growth and the IRR seems reasonable. Management should examine historical records and future business potential to determine if the project sustains a growth opportunity to reinvest cash flows at a high IRR. If the IRR seems unrealistic, the NPV method should be preferred.
Payback Period and NPV: Payback period does not consider the time value of money and the cash flows that are paid or received after the payback period. As the idea that the payback period provides about how long the invested capital is at risk is pretty rough, NPV is introduced as a more reliable method of capital budgeting to determine a project’s worthiness.