Capital investment analysis techniques are crucial for making smart financial decisions. Net Present Value (NPV) and Internal Rate of Return (IRR) are two key methods used to evaluate potential investments, each with its own strengths and limitations.

When comparing these techniques, it's important to understand their differences and how they apply to various scenarios. NPV is generally preferred for its direct measure of value creation, while IRR is often favored by managers for its intuitive percentage format. Both methods have their place in capital budgeting decisions.

Capital Investment Analysis Techniques

Net present value calculation

• Net Present Value (NPV) measures difference between present value of cash inflows and outflows
• Formula: $NPV = \sum_{t=0}^{n} \frac{CF_t}{(1+r)^t}$ where $CF_t$ is cash flow at time t, r is discount rate, n is number of periods
• Calculate NPV: estimate future cash flows, determine discount rate, discount to present value, sum all discounted flows
• Interpret results: positive NPV adds value (accept), negative NPV destroys value (reject), zero NPV breaks even (indifferent)
• NPV advantages: considers time value of money, accounts for all cash flows over project life
• NPV limitations: sensitive to discount rate selection, assumes reinvestment at discount rate

Internal rate of return computation

• Internal Rate of Return (IRR) is discount rate that makes NPV of project zero
• Formula: $0 = \sum_{t=0}^{n} \frac{CF_t}{(1+IRR)^t}$
• Calculate IRR: use trial and error approach or financial calculators/spreadsheet functions
• Interpret results: compare IRR to required rate of return (hurdle rate), accept if IRR > hurdle rate, reject if IRR < hurdle rate
• IRR advantages: provides easily comparable percentage return, doesn't require predetermined discount rate
• IRR limitations: multiple IRR problem for non-conventional cash flows, assumes reinvestment at IRR, scale insensitive

Comparing Capital Budgeting Techniques

NPV vs IRR in capital budgeting

• Similarities: both consider time value of money, use same cash flow inputs
• Differences: NPV gives absolute value while IRR provides percentage return, NPV assumes reinvestment at discount rate while IRR at its own rate
• Decision criteria: NPV (accept if positive, reject if negative), IRR (accept if > hurdle rate, reject if lower)
• NPV generally preferred by academics for directly measuring value creation
• IRR often favored by managers due to intuitive percentage format
• NPV better for comparing projects of different sizes or durations

Evaluation of mutually exclusive projects

• Mutually exclusive projects allow only one project to be chosen from a set
• NPV approach: select project with highest positive NPV, accounts for scale differences
• IRR approach: highest IRR may not always indicate best project, potential for IRR-ranking conflict
• Incremental IRR analysis: calculate difference in cash flows between projects, compute IRR of incremental cash flows, compare to hurdle rate
• Crossover rate: point where NPV of two projects is equal, helps understand preference reversal
• Consider capital rationing, risk profiles, and strategic fit when selecting projects