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The most reliable criteria for selecting business projects are reckoned to be the discounted cash-flow capital budgeting criteria. To assist Guillermo make the best choice, four selection criteria are used. The Net present Value (NPV), the Profitability Index (PI), and the Internal Rate of Return (IRR) use discounted cash flows while the Payback Period is a non-cash discount method.
The table below ranks the three options available to Guillermo. To justify why all the selection criteria pick option three as the best, one has to study the nature of the criteria and understand how they are applied in the real world.
The NPV method discounts all future cash flows to the present using the Required Rate of Return or a weighted average cost of capital (WACC). The difference between the sum of the discounted cash flows and the initial capital outlay gives what Petty et al. call “…the net value of accepting the investment proposal in terms of today’s dollars” (347). As a rational businessman, Guillermo has to choose the option that gives him the highest value today. That is option 3.
Profitability Index “is the ratio of the present value of the future cash flows to the initial outlay.” (Petty et al 350) In his b,ook Financial Management Khan points out that the fact that NPV is an “absolute measure, it is not a reliable method to evaluate projects requiring different initial investments” (31). PI provides a solution to this shortcoming because it is a “relative measure” (Khan 31) Becoming a broker is the best option for Guillermo because the benefits are 2.63 more than the costs. This is ratio is higher than the rest of the other options.
The IRR is the rate of return that a business projects earns. In other words, this is the rate that makes the PV equal to the initial outlay. The IRR accept/reject criterion is: if IRR< RRR rejects the investment. If IRR > then RRR accept the investment. If choosing option 1 who’s IRR is less than the RRR of 6.1% is considered as diminishing the value of Guillermo then choosing option 3 with the highest IRR of 16.60% will add remarkable value to the company. Helfert explains that the IRR is attractive because it easily “compares with the cost of capital as it is stated in percentage terms (243).
The payback period method measures the time it takes for the cash flows coming in from the investment to repay the initial outlay. The earlier the investment recoups its initial out lay the better. It will take Guillermo only six months to recover his initial outlay if he becomes a broker. Of all the three options this is the shortest and hence the best option.
It has to be appreciated that it takes more than just gut feeling to select option 3. The capital budgeting business selection methods discussed above apply fundamental finance principles. The NPV method acknowledges the ‘time value for money.’ This principle states that a dollar on hand now is better than a dollar in the future. For Guillermo, the option that gives him the most dollars now is what he should choose.
The IRR recognizes the risk/return trade-off. The principle states that “one should not take the additional risk unless they expect to be compensated with additional return” (Petty et al. VI). Guillermo has to choose the option that is expected to give him the highest returns. The methods also recognize the time-proven fact that cash flows are a better measure of a company’s status than profits.
References
Helfert, Erich. Financial Analysis: Tools and Techniques: Guideide for Managers. McGraw Hill Companies USA. 2001.
Khan, M.Y. and Jain, P.K. Financial Management: Text, Probl,ems, and Cases. Tata McGraw-Hill. New Delhi, India. 2007.
Petty, William. Keown Arthur. Scott Jr. David. Martin John. Martin Peter. Burrow Michael, and Nguyen Hoa. Financial Management, 5th ed. Pearson Education, Australia. 2009. Print.
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