We talked about capital budgeting and the basics of NPV and DCF in an earlier post. Here we will explore in detail the concepts used in capital budgeting, something that is essential for every investment analyst and manager alike.
The sub-categories of capital budgeting include Net Present Value (NPV), Internal Rate of Return (IRR), Accounting rate of return (ARR), Payback period and Discounted Payback period. Most of us have heard of NPV and IRR. In any project manager role, these two are crucial to evaluate the feasibility of a project.
NPV is the sum of all discounted cashflows of an entity. To calculate NPV, you first need to ascertain the period that you are estimating cashflows for. Once you have that and the cashflows in hand, each cashflow is discounted by a discount factor. The discount factor is the rate by which the value of money depreciates on a periodic basis.
NPV of an entity is the deciding value of the entity. IF NPV is lesser than zero, the entity is assumed to generate a loss on investment. An NPV greater than zero generates a positive return on investment. While NPV is the best way to assume the profitability of a project, it is not a variable for which you can set a target.
And that is where IRR comes in. IRR Is defined as the discount rate at which NPV is zero. In other words, it is an indicator of a project’s return. Most companies use an IRR target to determine if a project is worth pursuing. While IRR is a great indicator to use when cashflows are predictable and te time horizon is small, it has its limitations.
Accounting rate of return is another factor that is used commonly. Simply put, it is the sum of all annual net income divided by initial investment. ARR is a simple metric, and avoids time value discounting of money. It is used in comparison of projects and judge basic profitability of a project to an investor.
Payback, as the term suggests, is the timeframe that it takes to recover an investment. Sometimes, there is a balancing act that is done between IRR and payback. Projects with higher profitability potential but longer payback periods are sometimes traded off for lower-profitability but shorter-tenure projects.
And finally, discounted payback is simply applying the time value of discounting to payback. In this case, you compare the initial investment to the sum of discounted cashflows to determine when you recoup the outlay.