Four alternative methods of project evaluation and selection are discussed in this article. The first is a simple additive method for assessing the worth of a project called the payback period. The remaining three methods (internal rate of return, net present value, and profitability index) are all discounted cash flow techniques.
The payback period (PBP) of an investment tells us the number of years required to recover our initial cash investment. Although this measure provides a rough guide to the liquidity of a project, it is a poor gauge of profitability. It falls short as a measure of profitability because it (1) ignores cash flows occurring after the expiration of the payback period, (2) ignores the time value of money, and (3) makes use of a crude acceptance criterion, namely, a subjectively determined cut off point.
The internal rate of return (IRR) for an investment proposal is the discount rate that equates the present value of the expected net cash flows with the initial cash outflow. If a projectâ€™s IRR is greater than or equal to a required rate of return, the project should be accepted.
The net present value (NPV) of an investment proposal is the present value of the proposalâ€™s net cash flows less the proposalâ€™s initial cash outflow. If a projectâ€˜s NPV is greater than or equal to zero, the project should be accepted.
The profitability index (PI), or benefit-cost ratio, of a project is the ratio of the present value of future net cash flows to the initial cash outflow. If a projectâ€™s PI is greater than or equal to 1.00, the project should be accepted.
When two or more investment proposals are mutually exclusive, so that we can select only one, ranking proposals on the basis of the IRR, NPV, and PI methods may give contradictory results. If a conflict in rankings occurs, it will be due to one or a combination of the following three project differences: (1) scale of investment, (2) cash-flow pattern, and (3) project life. In every case, the net present value rankings can be shown to lead to the correct project selection. In short, if net present value rankings are used, projects that are expected to add the greatest increment in dollars value to the firm will be chosen.
A potential problem with the internal rate of return method is that multiple internal rates of return might occur for non-conventional projects whose cash-flow streams show multiple changes in sign. When there are multiple rates of return, an alternative method of analysis must be used.
Capital rationing occurs any time there is a budget ceiling, or constraint, on the amount of funds that can be invested during a specific period, such as a year. When capital is rationed over multiple periods, several alternative (and rather complicated) methods can be applied to the capital rationing problem. If capital is to be rationed for only the current period, selecting projects by descending order of profitability index generally leads to a firm value.
It is important to monitor projects continually to help ensure project success. Therefore, companies should perform progress reviews followed by post completion audits.