Three discounting techniques of capital budgeting

Discounting techniques discount the cash flows at the cost of capital and consider all benefits and costs over the whole life of the project.

1. Net present value (NPV)

• NPV = Σ CFt ÷ (1 + k)ᵗ − C0: the present value of the cash inflows at the cost of capital less the initial investment.
• Decision: accept if NPV > 0, reject if NPV < 0; rank by NPV.
• Merits: allows for the time value of money and all cash flows; measures the absolute gain in shareholders' wealth. Limitations: needs the cost of capital; an absolute figure, so it does not show return per rupee.

2. Internal rate of return (IRR)

• The rate r at which the present value of the inflows equals the outlay (NPV = 0), found by trial and interpolation.
• Decision: accept if IRR > cost of capital.
• Merits: allows for time value and all cash flows; easy to compare with the cost of capital. Limitations: tedious; may give several rates; assumes reinvestment at the IRR; can mislead with mutually exclusive projects of different size.

3. Profitability index (PI)

• PI = present value of cash inflows ÷ present value of cash outflows (the benefit-cost ratio).
• Decision: accept if PI > 1; PI > 1 means a positive NPV; rank by PI where funds are limited.
• Merits: allows for time value; a relative measure of profitability per rupee. Limitations: same cash-flow and discount-rate estimates as NPV; may conflict with NPV for projects of different size.