Mostfinancial firms and companies usually have to make decisions aboutprojects. These decisions mainly revolve around whether to financethose projects or not. Several decision-making matrices are used tomake such decisions. The reason behind this whole process is toensure that a company or a firm will not invest blindly in a riskyproject and they end up losing money. Therefore, these capitalbudgeting decisions are very important in safeguarding the financialsecurity of the company. The most commonly used decision makingprotocols include the Payback Period, Net Present Value (NPV) and theInternal Rate of Return (IRR) (Graham &Harvey, 2001). Thesedecision-making matrices are further discussed below.
Thisis the length of time that a venture would take to pay back the fullamount that was invested in it. It is determined by calculating thetotal cost of the project divided by the expected future cash inflow.This is a relatively simple means of determining the feasibility of agiven project and therefore enables the firm or company to decidewhether to fund the project or not. A project with a shorter paybackperiod is usually opted for than the one that has a longer paybackperiod. This method is a non-discounted cash flow means ofdecision-making, as it does not put into account the uncertainty offuture cash inflow (Kester & Chong, 1998). Therefore, it is not avery conclusive method to be used for making capital budgetingdecisions.
Thismethod is more commonly used and it is more effective when makingcapital budget decisions. This method works by finding the differencebetween the total cost of the project and the cash flows that theproject is expected to generate. This decision-making metric uses thediscountable cash flow analysis. This means that future cash flowuncertainties are put into the calculations and thus prediction ofthe feasibility of a given project becomes more accurate. This makesthis method to be more useful than the payback period.
InternalRate of Return
Thisis the most commonly used method of decision-making criteria. Itinvolves determining a number of returns the investor is expected tomake from a given project. A project that has a higher rate of returnthan the amount used to fund the project is usually preferred. UnlikeNPV, IRR is shown using percentages. This method also uses thediscounted cash analysis and thus it is highly effective inprediction.
Themost preferred metric for decision-making by most firms is usuallythe IRR. Although both the NPV and IRR use discounted cash flowanalysis to make their predictions on investments more accurate, theIRR displays its results in percentages, which is more appealing toinvestment firms than the solid figures that are used in NPV (Kesteret al., 1999). The IRR decision-making criteria is therefore the mosteffective metric to be used by any financial firm or company toreduce investment risks.
Graham,J.R., and C.R. Harvey (2001). The theory and practice of corporatefinance: Evidence from the field. Journal of Financial Economics,60(2-3):187-243.
KesterG W., R.P. Chang, E. S. Echanis, S. Haikal, M.Md. Isa, M.T. Skully,K. Tsui and C. Wang (1999). Capital budgeting practices in the Asiapacific region: Australia, Hong Kong, Indonesia, Malaysia,Philippines, and Singapore. Financial Practice and Education 9(1):25-33.
Kester,G.W., and T.K. Chong 1998. Capital budgeting practices of listedfirms in Singapore. Singapore Management Review 20(1): 9-23.