What are NPV, IRR, DCF… in capital budgeting?

(This post explains what are NPV, IRR, DCF, Time value of money, Hurdle rate or opportunity cost of capital, accounting rate of return, pay- back period etc.)

The price of groceries or any other items purchased by you today will not be same next year. The purchasing ability of a Rupee today is different (normally more than the same) next year.  This awareness of money value is called time value of money (TVM).

Net Present Value or NPV is the method used for evaluating investment projects or proposals calculating the difference between the present values of cash outflows with inflow of cash at future date using appropriate discount on time value of money. As per NPV rule the company should accept projects where the NPV is positive and reject where the NPV is negative.  In the other words, the proposed project will be accepted if projected cash inflow outweighing cash outflows on a present value basis. The positive NPV figure signifies that future cash flows are sufficient to repay the initial investment along with the opportunity cost associated with the project. The company rejects the proposal if NPV is negative. Similarly if the company is considering starting any one of the two exclusive projects, the one with the higher NPV will be chosen.

The internal rate of return (IRR) method of evaluation is that discount rate assuming net present value NPV equal to zero. Unlike NPV method, the discounting rate is not known in the IRR method and it is found out by using trial and error basis or extrapolating and interpolating methods. For evaluation purpose, IRR is compared with the cost of capital of the company.

Discounted Cash Flow (DCF) is a method of valuation of project using the time value of money. All future cash flows are projected and discounted them to arrive at a present value estimate. Such method of discounting future inward and outward cash flows to find out the present value of cost of investment is called discounted cash flow (DCF) analysis. This method of analysis  is useful in evaluating the potential for investment.

Hurdle rate: In capital budgeting, the opportunity cost of capital (also known as the hurdle rate) is the minimum rate that a company expects to earn when investing in a project. Hence the hurdle rate is also referred to as the company’s required rate of return or target rate. In order for a project to be accepted, its internal rate of return must equal or exceed the hurdle rate.

Accounting rate of return: Accounting rate of return, or Average rate of return (ARR)  is a financial ratio used in capital budgeting. The ARR is calculated differently from concept of Time Value of money. It calculates the percentage of net income (after tax) out of the return generated from   proposed capital investment. The ratio of accounting rate of return is obtained through dividing the expected average profit by the initial investment.

Payback period: Payback period is the method to calculate within how many years the company gets its investment back. Suppose, a company invests Rs.200 crores in a project and future stream of revenue is expected to be Rs.50 crores for the first 5 years. Then, the payback period is 200/50 = 4 years. In effect, during the period of first 4 years, the company gets its investment back and revenue after this period is the profit for the company. Payback period is the method of evaluation where no discounting of cash flow comes into play.

Related articles:

1. What is capital budgeting?
2. What is Benefit to cost ratio?
3. How to calculate Discount rate/discount factor?