What are the basic components of capital budgeting analysis? Explain the difference between IRR and NPV Methods.

Components of capital Analysis

The capital budgeting process is a measurable way for businesses to determine the long-term economic and financial profitability of any investment project.

Capital budgeting is also vital to a business because it creates a structured step by step process that enables a company to:

1. Develop and formulate long-term strategic goals – the ability to set long-term goals is essential to the growth and prosperity of any business. The ability to appraise/value investment projects via capital budgeting creates a framework for businesses to plan out future long-term direction.
   
2. Seek out new investment projects – knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry.
   
3. Estimate and forecast future cash flows – future cash flows are what create value for businesses overtime. Capital budgeting enables executives to take a potential project and estimate its future cash flows, which then helps determine if such a project should be accepted.
   
4. Facilitate the transfer of information – from the time that a project starts off as an idea to the time it is accepted or rejected, numerous decisions have to be made at various levels of authority. The capital budgeting process facilitates the transfer of information to the appropriate decision makers within a company.
   
5. Monitoring and Control of Expenditures – by definition a budget carefully identifies the necessary expenditures and R&D required for an investment project. Since a good project can turn bad if expenditures aren't carefully controlled or monitored, this step is a crucial benefit of the capital budgeting process.
   
6. Creation of Decision – when a capital budgeting process is in place, a company is then able to create a set of decision rules that can categorize which projects are acceptable and which projects are unacceptable. The result is a more efficiently run business that is better equipped to quickly ascertain whether or not to proceed further with a project or shut it down early in the process, thereby saving a company both time and money.

Difference between IRR and NPV Methods

Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include:

• NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return;

• Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;

• The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);

• However, the IRR Method does have one significant advantage — managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,

• While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash.

• Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.