The assessment of potential investment planning process involves the different types of capital budgeting and investment appraisal techniques. The incorporation of such techniques plays a pivotal role in deterring the long- term investment decisions. Some of these are seen in form of application of the different methods, which is required for replacement of machinery, implementation of a new machinery or introduction of new products. The various types of capital budgeting techniques are listing below as follows:
- Payback Period
- Average accounting return
- Profitability Index
The aforementioned techniques for the project appraisal are based on the incremental cash flows sourced from the individual investment opportunity. Among the several types of the investment appraisal techniques it has been seen that capital budgeting techniques such as the sue of NPV and IRR are considered to be most effective as they take into consideration time value of money (Jan, Irfanullah 2017).
The Net Present Value method has been identified to be the most appropriate method as it is considered most appropriate in terms of the long term project planning. The most important aspect of the consideration of the NPV is the time value of money, which is not present in the other methods of project evaluation. It takes into consideration the incremental cash flow value (https://www.accaglobal.com 2017). In case the value of NPV is observed to be zero then the cash flow of the project is observed to be just enough to meet the required rate of investment and the total payback time of the money. In case the NPV is positive, there is enough cash flow to compensate the payback of the debt of the project. Hence, positive value of NPV is always a preferred measured for making an investment in the project. Another reason for the preference of the NPV method has been seen due its projections based in currency values, such as dollars or pound sterling. NPV is flexible to handle multiple discount rates without any problems. The different types of the other advantages can be further seen ion term of discounting the cash flows separately from others (Merritt, Cam 2017).
The IRR is often identified as the “internal rate of return (IRR)”. This particular method is associated to calculate the rate of return. This rate is defined as the annualized effective CRR (Compounded Return Rate). This method is particularly beneficial for evaluating the desirability of investments or projects. The higher is IRR; more preferred it has been observed undertake a particular project.
The relation between the IRR and NPV is seen in terms of the effective compounding of the interest rate, which is used to make the NPV of the cash flows from a particular project equal to zero. It has been further observed that this value of the cash flow can be both positive and negative in nature. Similar to NPV, Internal Rate of Return also takes into consideration the time value of the money. It also considers the required rate of return and the increasing or the decreasing cash flows similar to NPV techniques. The only distinctive feature of the IRR is seen with percentage expressing of internal rate, whereas NPV is shown in terms of dollar value. The various types of the other relation can be seen in terms of the same depiction in terms of the positive, negative and zero values of IRR (Kaushal, Neha 2017).
IRR is effective measure of capital budgeting as it is known to simplify multiple projects into a single project. Management can further use this information to determine the viability of the project. This method has been also seen to be viable for long-term projects. This technique is applicable for cash flows, which is observed to have certain returns. Another advantage of IRR is that takes into account one single discount rate to evaluate every investment (Schmidt, Robert 2017).
https://www.accaglobal.com, ACCA. 2017. "Incremental Cash Flows | FFM Foundations In Financial Management | Foundations In Accountancy | Students | ACCA | ACCA Global". Accaglobal.Com. https://www.accaglobal.com/in/en/student/exam-support-resources/foundation-level-study-resources/ffm/ffm-technical-articles/incremental.html.
Jan, Irfanullah. 2017. "Capital Budgeting | Techniques | Introduction". Accountingexplained.Com. https://accountingexplained.com/managerial/capital-budgeting/.
Kaushal, Neha. 2017. "NPV Vs IRR - Which Is Better? - Wallstreetmojo". Free Investment Banking Tutorials | Wallstreetmojo. https://www.wallstreetmojo.com/npv-vs-irr/.
Merritt, Cam. 2017. "Net Present Value Method Vs. Payback Period Method". Smallbusiness.Chron.Com. https://smallbusiness.chron.com/net-present-value-method-vs-payback-period-method-61578.html.
Schmidt, Robert. 2017. "What Is IRR And How Does It Work?". Propertymetrics.Com. https://www.propertymetrics.com/blog/2014/06/09/what-is-irr/.