CAPITAL BUDGETING - NPV, IRR, MIRR, PAYBACK

There are six different methods used to analyze capital projects. They are net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), payback, and discounted payback.

The NPV method estimates the future relevant cash flows and discounts those values to today’s value. The sum of those discounted cash flows less the investment cost is equal to the NPV. If the NPV equals zero than the project will generate enough cash flow to pay off the cost of debt and equity used to finance the project. Positive NPV adds EVA (Economic Value Added) for the company. Using NPV is the most reliable method to determine if a capital project will be profitable.

The IRR method is most commonly used among Fortune 500 companies because it is easy to communicate a project’s profitability in percentage terms. The IRR is that rate that when used to discount relevant cash outflows and inflows equate NPV to equal zero. IRR is not a reliable rate when cash flows change signs more than once.

The modified internal rate of return (MIRR) is a more appropriate method than IRR when a company has Nonnormal cash flows. Nonnormal cash flows exist when a company starts off with positive cash flows then has negative cash flows and then returns to positive cash flows. Using the IRR method for Nonnormal cash flows will result in multiple IRRs. A better indicator of relative profitability is the modified IRR or MIRR. This method discounts future cash outflows and calculates future value of cash inflows using the cost of capital. The discount rate that causes the present value of the future value of cash inflows to equal the present value of costs is defined as the MIRR.

The Profitability Index is another method to value capital projects. The PI takes the present value of future cash flows and divides it by the initial cost. The PI tells us how much cash inflows are being generated for each dollar of investment cost. A project is acceptable if its PI is greater than 1.0 which means the NPV is greater than zero dollars.

The payback period is a method that tells how long it will take to recapture the investment cost without taking into account the time value of money. The payback period also doesn’t give consideration to cash inflows after the initial investment is recovered, and doesn’t tell us by how much the project will increase shareholders wealth or by how much the IRR exceeds the cost of capital.

Some firms use a modified method to the payback period called the discounted payback period which discounts the project’s cash inflows by the project’s cost of capital. The discounted payback corrects the one flaw of the payback period and discounts future cash inflows. However, it still disregards cash inflows after the payback year and, as with regular payback has no connection with wealth maximization.

There are a number of different methods that a company can use to make capital budgeting solutions. No one method by itself is a perfect indicator of value, risk, and shareholder wealth maximization. Each method has its advantages and flaws. NPV which is probably regarded by academia as the most reliable indicator of a capital projects worth doesn’t provide a “safety margin”. When evaluating two mutually exclusive projects using NPV, the results don’t tell you the IRR for each project. Depending on the size of the project and cash inflows one project could have a higher NPV, but a smaller safety margin; meaning a higher NPV could have a smaller IRR, and a change in cash flows from projected could have a more significant impact than the project with a smaller NPV, but higher IRR.

IRR allows an evaluation of the cost of capital rate versus the internal rate of return, but if the project switches back and forth between positive and negative cash flows you end up with multiple IRRs which makes the project difficult to evaluate. In that case the MIRR can be used as a more reliable evaluation tool, but as discussed in the introduction still has its flaws.

Payback and discounted payback provide an indication of the projects liquidity and risk. A project with a long-term payback means that a company’s funds will be tied up for a long period, and secondly, it increases the likelihood that the project will not deliver the projected cash flows and thus, fail.

Since each method provides unique information to the project’s profitability, liquidity, and risk, all methods should be used to make capital budgeting decisions. Management should not use just quantitative methods to make capital budgeting decisions, but take into account qualitative factors such as tax policy, government stability, demographic shifts, etc. Managers should ask tough questions when evaluating capital projects. In a perfect competitive environment there would be no positive NPV because all companies would have the same opportunities, and any positive NPV would quickly be eliminated by the competition. So there has to be some imperfection that gives a company a competitive advantage and creates a positive NPV that will last for a long period of time. Managers need to be able to identify this imperfection that might exist from a patent or advanced technology.
In conclusion, managers need to find competitive advantages that will generate positive NPV that can’t easily be duplicated, and when presented with projects that show a high NPV they need to ask the tough questions and play devils advocate.