Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions

Summary of the Strengths and Weaknesses of the Time Value-Based Capital Budgeting Methods

Time value-based capital budgeting methods are best used after an initial screening process, when a company is choosing between few alternatives. They help determine the best of the alternatives that a company should pursue. Two such methods are net present value and internal rate of return. Their strengths and weaknesses are presented in Table 11.6 and Table 11.7.

Net present value converts future cash flow dollars into current values to determine if the initial investment is less than the future returns.



Net Present Value

Strengths Weaknesses

  • Considers the time value of money
  • Acknowledges higher risk investments
  • Comparable future earnings with today's value
  • Allows for a selection of investment
  • Requires a more difficult calculation than non-time value methods
  • Required return rate is an estimate, thus any changes to this condition and the impact that has on earnings are unknown
  • Difficult to compare alternatives that have varying investment amounts

Table 11.6

Internal rate of return looks at future cash flows as compared to an initial investment to find the rate of return on investment. The goal is to have an interest rate higher than the predetermined rate of return to consider investment.

Internal Rate of Return

Strengths Weaknesses

  • Considers the time value of money
  • Easy to compare different-sized investments, removes dollar bias
  •  A predetermined rate of return is not required
  • Allows for a selection of investment
  • Does not acknowledge higher risk investments because the focus is on return rates
  • More difficult calculation than non-time value methods, and outcome may be uncertain if not using a financial calculator or spreadsheet program
  • If the time for return on investment is important, IRR will not place more importance on shorter-term investments

Table 11.7

After a time-value based capital budgeting method is analyzed, a company can be move toward a decision on an investment opportunity. This is of particular importance when resources are limited.

Before discussing the mechanics of choosing the NPV versus the IRR method for decision-making, we first need to discuss one cardinal rule of using the NPV or IRR methods to evaluate time-sensitive investments or asset purchases: If a project or investment has a positive NPV, then it will, by definition, have an IRR that is above the interest rate used to calculate the NPV.

For example, assume that a company is considering buying a piece of equipment. They determine that it will cost $30,000 and will save them $10,000 a year in expenses for five years. They have decided that the interest rate that they will choose to calculate the NPV and to evaluate the purchase IRR is 8%, predicated on current loan rates available. Based on this sample data, the NPV will be positive $9,927 ($39,927 PV for inflows and $30,000 PV for the outflows), and the IRR will be 19.86%. Since the calculations require at least an 8% return, the company would accept the project using either method. We will not spend additional time on the calculations at this point, since our purpose is to create numbers to analyze. If you want to duplicate the calculations, you can use a software program such as Excel or a financial calculator.

CONCEPTS IN PRACTICE

Solar Energy as Capital Investment

A recent capital investment decision that many company leaders need to make is whether or not to invest in solar energy. Solar energy is replacing fossil fuels as a power source, and it provides low-cost energy, reducing overhead costs. The expensive up-front installation costs can deter some businesses from making the initial investment.

Businesses must now choose between an expensive initial capital outlay and the long-term benefits of solar power. A capital investment such as this would require an initial screening and preference process to determine if the cost savings and future benefits are worth more today than the current capital expenditure. If it makes financial sense, they may look to invest in this increasingly popular energy source.


Now, we return to our comparison of the NPV and IRR methods. There are typically two situations that we want to consider. The first involves looking at projects that are not mutually exclusive, meaning we can consider more than one possibility. If a company is considering non-mutually exclusive opportunities, they will generally consider all options that have a positive NPV or an IRR that is above the target rate of interest as favorable options for an investment or asset purchase. In this situation, the NPV and IRR methods will provide the same accept-or-reject decision. If the company accepts a project or investment under the NPV calculation, then they will accept it under the IRR method. If they reject it under the NPV calculation, then they will also reject it under the IRR method.

The second situation involves mutually exclusive opportunities. For example, if a company has one computer system and is considering replacing it, they might look at seven options that have favorable NPVs and IRRs, even though they only need one computer system. In this case, they would choose only one of the seven possible options.

In the case of mutually exclusive options, it is possible that the NPV method will select Option A while the IRR method might choose Option D. The primary reason for this difference is that the NPV method uses dollars and the IRR uses an interest rate. The two methods may select different options if the company has investments with major differences in costs in terms of dollars. While both will identify an investment or purchase that exceeds the required standards of a positive NPV or an interest rate above the target interest rate, they might lead the company to choose different positive options. When this occurs, the company needs to consider other conditions, such as qualitative factors, to make their decision. Future cost accounting or finance courses will cover this content in more detail.