Long term Investment Decision: Capital Budgeting Techniques

The financial manager must apply appropriate decision techniques to assess whether proposed investment projects create value. Net present value (NPV) and internal rate of return (IRR) are the generally preferred capital budgeting techniques. Both use the cost of capital as the required return. The appeal of NPV and IRR stems from the fact that both indicate whether a proposed investment creates or destroys shareholder value. NPV clearly indicates the expected dollar amount of wealth creation from a proposed project, whereas IRR only provides the same accept-or-reject decision as NPV. As a consequence of some fundamental differences, NPV and IRR do not necessarily rank projects in the same way. NPV is the theoretically preferred approach. In practice, however, IRR enjoys widespread use because of its intuitive appeal. Regardless, the application of NPV and IRR to good estimates of relevant cash flows should enable the financial manager to recommend projects that are consistent with the firm’s goal of maximizing shareholder wealth.

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