Compare and contrast the Internal Rate of Return (IRR), the Net Present Value (NPV) and Payback approaches to capital rationing. Which do you think is better? Why?
The internal rate of return (IRR), net present value (NPV), and the payback approach are all methods that enable the process of capital budgeting by helping to analyze investment profitability. According to Byrd, Hickman & McPherson (2013), IRR is “the discount rate that equates their present value of an investment’s future cash flows with the investment cost” (p. 199). The IRR helps to identify the potential profits of an investment; the higher the IRR the more profitable the investment is considered to be. However, the NPV, distinguishes the current value of future cash flow from an initial investment (Byrd, Hickman & McPherson,2013). Both the IRR and NPV provide an estimate of profitability, however the NPV reports a dollar value of a return versus the IRR reports a percentage of return. The payback approach is used to estimate the time period that will be needed to recoup the initial investment (Byrd, Hickman & McPherson, 2013). Unlike the IRR and NPV methods the payback approach is more simplified as there is no converting required and it does account for inflation.
In my opinion, I believe the NPV method is the best of all three. Financial managers tend to prefer the NPV method because it provides a more accurate valuation. According to Bosch, Montllor-Serrats & Tarrazon (2007), “net present value incorporates the complete set of value drivers of the investment project, while the internal rate of return is just one of them” (p. 43). Additionally, compared to the IRR and payback approach, the NPV can provide more information to assistance in decision -making. According to Prall (1990), the payback method “does not provide a valid basis for most decisions because it ignores all returns after the initial investment has been recovered. Ultimately, while each concept has its advantages, the NPV is going to give a more accurate picture in the investment decision making process.
Bosch, M., Montllor-Serrats, J., & Tarrazon, M. (2007). NPV as a function of the IRR: The value drivers of investment projects. Journal of Applied Finance, 17(2), 41-45. Retrieved from https://search-proquest-com.proxy-library.ashford.edu/docview/201576249?accountid=32521
Byrd, J., Hickman, K., & McPherson, M. (2013). Managerial Finance [Electronic version]. Retrieved from https://content.ashford.edu/ (Links to an external site.)
Prall, J. R. (1990). The capital budget decision: A publication of the American association of cost engineers a publication of the American association of cost engineers. Cost Engineering, 32(12), 19. Retrieved from https://search-proquest-com.proxy-library.ashford.edu/docview/220451996?accountid=32521
Capital budgeting, capital rationing, or capital allocation as the term I used in large companies represents the planning and forecasting that accompany decisions to invest significant amounts of money into assets or concepts that have a long term value to the company. Internal Rate of Return (IRR) compares the expected return for a project to the required return on investment specified by the investors (Byrd, Hickman, & McPherson, 2013). When I worked in the planning and management of large projects for Bank of America we referred to the desired rate of return as the hurdle rate.
Net Present Value (NPV) measures the amount of financial benefit that a project offers in current dollars by measuring the present value of future cash flows, minus investment costs (Byrd et al., 2013).
The Payback methodology estimates how many years it will take to recoup the project’s initial investment (Byrd et al., 2013). The payback is usually calculated by measuring the project’s net gain or the additional income or productivity the project or asset creates. The 11th van payback would be determined from the net profit created by both the van and the plumber service. Decisions using a payback model are usually made using the excess profits produced above the necessary yield rate (Juhasz, 2011). In this case, the usual rate of return is the profit of the first 10 trucks, so the profit of the 11th truck is exceeding.
The NPV definition has historically assumed that the rate of return on cash flows for reinvestment is equal to the risk-adjusted discount rate (Wong, 2000). The two rates are actually different in many cases however. Therefore, if an organization tries to list projects based on a rate of return, the NPV may not make the projects correctly stacked. That’s why many financial managers favor using IRR as the benchmark for choosing a return-based project target. This lack of confidence is mainly due to the data arising from the NPV versus the IRR. At the end of an NPV analysis a single monetary amount is determined for a project, say $10,000 positive NPV. Furthermore, since the difficulty is not apparent, the number does not provide a reference to other projects. Nevertheless, IRR returns a percentage that can be matched with the norm, and a project ranking will take place directly from the percentage score. If a company’s hurdle rate is 10%, then a project with a 15% IRR would be a better financial choice than a 12% project. Both might however have the same NPV depending on the internal costs and returns.
The Payback approach tends to be even simpler. This basically dictates how quickly the money will be repaid. It is not dependent on a hurdle rate ranking, or percentage. But, for small and medium sized companies it normally means the most critical measurement. The Payback shows how long it will be before the project breaks even, often this period of time represents debt or high opportunity cost funding.
Personally, I prefer the NPV and the Payback. My favorite is to use the Payback formula. I believe that the IRR offers too many opportunities for managers to game the system. In the 1980s while working as a project manager for Bank of America I was held to a strict IRR hurdle rate scenario for projects. I had a staff of financial analysts that would calculate the IRR on a project. I had a Financial Analysts team estimating an IRR on a project. I would also calculate an IRR, conclude that it did not meet the hurdle threshold and give the details to the vice president who wanted the project. The vice president would always tell me to change the cost, interest rate assumptions and revenue forecast in order to meet the IRR hurdle. The vice chairman simply wanted the IRR out of the way, so they could argue the project’s merits. The IRR was nothing short of annoyance.
The NPV and the Payback were most important when I was a commercial banker and was dealing with mid-size to small businesses. Cash, work capital, and access to money were the vital components of the market for these smaller companies. A project might have a fantastic IRR, but it actually ate up cash and working capital that were desperately needed if it didn’t return the cash fast enough or move the needle high enough on the operating profits.