Capital budgeting, the process of deciding which projects and investment opportunities to invest in is a critical aspect of a firm’s long-term success. Make the wrong decision and instead of creating value a company will end up reducing value. Make enough poor decisions in the capital budgeting process and the survival of the company may be at stake. How do you decide which projects have the potential to create value versus those that destroy value? You have to identify value creating opportunities by measuring the project’s or investment’s return.
To measure an opportunity’s return potential, there are a variety of metrics that can be used, all related but each providing its own perspective and information. The most commonly utilized project measurement metrics are net present value (NPV), internal rate of return (IRR), holding period return and payback period. There are others, but these are the most useful, and therefore the most commonly used. Between the four of them, they provide much of the information needed for decision makers to choose between competing alternatives.
Net present value, or NPV, provides an indication of a project’s or investment’s value. NPV is the sum of the present value of all the future cash flows, both cash inflows and cash outflows, related to the project (including immediate cash outflows). To discount the cash flows to present value, the firm’s cost of capital is typically utilized. If the project’s NPV is positive, then undertaking that project will add value. If the project’s NPV is negative, it indicates that moving forward with the project will actually reduce value.
Internal rate of return, or IRR, provides the project’s rate of return, typically expressed as an annualized return. Based on the cash inflows and outflows, the IRR is the discount rate that makes the present value of the future cash flows equal to the initial cost of the project (your immediate outlay to acquire the asset or implement the project). Another way of thinking about IRR is that it is the discount rate that makes the NPV of a project equal to $0 (and thus neither creates or reduces value).
Holding period return (sometimes referred to as return on investment, ROI, or return on invested capital (ROIC)) is the return on a project measured as the sum of the future cash flows (undiscounted) divided by the initial cost of the project (and then subtracting 1). It is a total return measure that provides the overall return from the investment, without regard to timing of the cash flows or consideration of the length of the holding period.
Payback period is the number of years (or some other preferred unit of time) to recover, or payback, the initial investment. It looks at undiscounted future cash flows by year, and compares them to the initial cost of the project. You can also calculate discounted payback period, which looks at discounted future cash flows by year, and then determines how long it takes to recover the initial cost of the project. Discounted payback periods will always be longer than payback periods (undiscounted).
Which one is best?
All four metrics provide useful information for decision makers, but they don’t always provide a definitive answer as to which option, when multiple options are available, is best. Project A may have a higher IRR than Projects B and C, but Project B might have the highest NPV while Project C has the shortest payback period.
In a perfect world, NPV would be the primary criterion, arguably the only criterion, one would need to measure and rely upon. When choosing among multiple mutually exclusive projects (you can only choose one), always choose the highest NPV option because that one will create the most value. When choosing among multiple non-mutually exclusive projects (you can choose multiple projects) pursue all positive NPV options. But we don’t live in a perfect world. Capital constraints, or the inability to quickly raise funds at your existing cost of capital, exist. A company may not have the ability to raise significant additional funds as needed or if they have the ability, they may not be able to do so quickly or at their existing cost of capital. Labor constraints may limit your current ability to pursue multiple projects at once or over a short window of time. It is with these considerations that other metrics become relevant. The following is a good general hierarchy of decision rules:
If capital and other constraints are not a concern, always choose the highest, positive NPV project. This will create the most value for your company.
If there are concerns which makes the highest NPV project undesirable, then IRR becomes critical. The project’s IRR has to exceed the company’s hurdle rate, which will typically be the company’s cost of capital. As a rule, if the project’s IRR exceeds the company’s cost of capital, then the project will have a positive NPV and is worth pursuing. If the IRR is less than the company’s cost of capital, the project will have a negative NPV. In that case the project will not create value, but destroy it.
Finally, if the company is needing or expecting a return of investment within a set period of time, then payback period becomes the relevant metric (again, as long as the IRR exceeds the hurdle rate). A project with an IRR less than the hurdle rate (negative NPV) will always destroy value, regardless of how short its payback period is.
Holding period return, while providing useful information, has limited usefulness as a decision metric, especially in isolation. By itself, it doesn’t indicate whether it will create or reduce value (like NPV and IRR can). However, when combined with NPV and/or IRR, it can be another metric to consider and help decide among competing options.
Your goal in the capital budgeting is to create value. You do that by allocating resources to projects and investments that will add value to the existing value of the company. But in order to successfully do so, you must be able to come up with your best estimate of which projects have the best potential to create value, and which projects to avoid as they will likely destroy value.
Best practices dictate that in a perfect world, always choose the highest NPV project. In fact, choose every project with a positive NPV. However, reality does not always create the perfect world conditions for us. In the face of capital and labor constraints, the highest NPV project may not automatically be the best choice. Even in those situations though, always choose a positive NPV project, never choose a negative NPV project. It is in these situations when IRR, payback period, and holding period return can be useful additional metrics to help allocate resources. After using NPV (and/or IRR) to eliminate value destroying options from the mix, you can use the secondary metrics to help you decide which remaining, value creating options to choose.
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