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Capital Budgeting Techniques

Which do you find better: NPV or the IRR and if IRR, do you consider MIRR?

Answers

Topic Expert
David Hughes
Title: Executive VP of Operations
Company: On Target Performance Group
(Executive VP of Operations, On Target Performance Group) |

I prefer, and I believe more companies use, IRR vs NPV. MIRR is technically more accurate but most companies use IRR. It is a little less complex and it is easier to simply adjust their hurdle rate to adjust for differences.

Topic Expert
Alan Hart
Title: Consultant
Company: Pacific Shine Group
(Consultant, Pacific Shine Group) |

IRR is usually adequate when the discount rate is not expected to change much over the course of the project or the investment, and is easier to calculate which is why most people use it over NPV. MIRR is generally more accurate than the original IRR method because it assumes that any positive cash flows that are re-invested are going to be at a different rate than the original project estimated rate of return. It is more complex, which is another reason most analyses use IRR.

Anonymous User
Title: CFO
Company: Local Government Agency
(CFO, Local Government Agency) |

Truthfully Wayne, in my experience as a budget manager, applying financial analysis to capital budgets never went to these standards. It was always as simple as "we have this much available that we can spend on capital projects". The projects were each evaluated and scored on a "needs" basis such as safety or security rating #1 and more efficient production falling below that. Then, the available capital funds were applied down the ratings lineup until the total funds were exhausted.

Sure, I'd love to have used IRR or even NPV. But, it just wasn't going to be a part of our capital budgeting process anywhere I have been.

Full disclosure: The largest capital budget I've ever been responsible for on a FT employment basis was $25M.

And, at a temporary position with a major telecom, it was hundreds of $millions but the driving decision maker was providing more service so as to capture market share ahead of the competition.

Topic Expert
Patrick Dunne
Title: Chief Financial Officer
Company: Milk Source
(Chief Financial Officer, Milk Source) |

We establish a high IRR (18%) and no project gets approved unless it meets this target. The exceptions include those that are needed for safety or business continuation.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

I would love to be a fly on the Wall when Capex decisions are being discussed on Amazon or Facebook where decisions are more longer term based and primarily for customer acquisition or service improvement.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

I think it would be an easier decision. Is this technology better or worse, and what is the downside if we don't buy.

Whether they have the cash or need to go to the well is moot, they must acquire the newest technology to stay current.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

So if I were to generalize the responses, IRR or just make the decision :)

Thanks...

Serge Wind
Title: Instructor, Department of Finance
Company: NYU School of Professional Studies
(Instructor, Department of Finance, NYU School of Professional Studies) |

Finance theory unambiguously suggests that NPV is always the best measure of value added – the ultimate arbiter of maximizing shareholder value. However, NPV is saddled with a couple of perceived deficiencies: (1) Business decision-makers abhor dollar returns associated with the NPV and favor percentage returns on initial investment, which are supplied by the IRR; and (2) the IRR provides information about the project’s “safety margin” – its sensitivity to changes in the discount rate and variances in cash flow (CF) inputs or capital at risk. IRR will provide the same ranking of mutually exclusive projects (competing projects of which only one can be undertaken) as the NPV, except if size and/or timing of CFs are factors, due to the unwarranted assumption that the project’s positive cash flows are re-invested in other projects at the unsustainable IRR which exceeds the cost of capital. In those circumstances and in the face of “non-normal” CFs (two changes of sign in the sequence of future CFs), MIRR will overcome the deficiencies of the IRR and prioritize and almost always mimic the selections gleaned from comparing NPVs without the first two reservations cited above. NPV, IRR and MIRR will assign the same priorities to “normal” independent projects. Finally, when analyzing mutually exclusive projects for a firm with capital constraints, IRR (or MIRR) is often used in place of the NPV, because it directs capital to the project with the highest return.

Summarizing the experience gleaned from coordinating an annual capital and investment program of $5.5 billion dollars several years ago, consulting on current capital budgeting practices, and an understanding of the theoretical rationale by finance underlying the exceptions noted suggests the now-common practice of calculating all three metrics, which use the same project data – the projected CFs of a project and its cost of capital – and following the guidelines expressed above in certain contingencies.

However, management and boards of directors feel more comfortable with one key metric prioritizing project selection, preferably a percentage rather than an absolute dollar measure. I would therefore recommend using the IRR as the dominant single measure in all cases, and shifting to the MIRR if: (a) the size and/or timing of the CFs of mutually exclusive projects produce different rankings via NPV and IRR; or (b) when dealing with “non-normal” future cash flow sequences.

Relative size of the cash flows of two projects may still occasionally suggest the rankings generated by the NPV measure are superior to those generated by the MIRR, and comparison of two projects with unequal lives calls for different techniques to compare the same number of years of CF expenditures and returns. No doubt there may be some other exceptions. Capital budgeting of investment projects is a complicated but vital process for each company.

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