Capital Budgeting Decisions Using Net Present Value and Internal Rate of Return Techniques

Abstract

Capital budgeting pertains to the determination of the organization’s long-term investments and their management. The investigation is focused on applying the NPV and IRR techniques in the assessment of investment decisions related to capital projects to determine whether such investments are feasible. These methodologies are critical in evaluating the potential value and profitability of cash flows in the future, especially in uncertain and risky environments. This analysis is carried out using secondary information obtained from a manufacturing firm’s investment opportunities within five years. Two mutually exclusive projects are considered employing the cash flow discounting technique from which NPV and IRR computations are derived from the expected inflows and outflows, at a discount rate of 12%. Sensitivity analysis is performed to determine the extent to which these methods and assumptions are valid and reliable. The findings suggest both NPV and IRR methods are aligned in most scenarios regarding project attractiveness; however, discrepancies occur in the presence of unconventional cash flow sequences and for projects with differing timelines. It is suggested that the project with the greatest NPV and an IRR above the cost of capital be pursued. Also, the study mentions other issues, such as the reinvestment rate of cash flows for IRR, as well as the instability of NPV due to the discount rate used. To summarize, this study illustrates the effectiveness of capital budgeting through NPV and IRR methods, provided the practitioners are cognizant of the underlying assumptions and constraints. Their combined use streamlines the capital budgeting process and trims the chances of faulty investment considerably