Termed as the cornerstone of capital budgeting, the NPV stipulates that the expected after-tax financial benefits and costs of an investment be calculated and netted over time. The netted cash flows and costs plough back to the present through discounting at rates reflecting the risks facing the investment and the possible course of inflation. Investments with positive NPV are preferable since theoretically they add to the value of the business by the magnitude of the NPV:

The NPV is useful due to its theoretical underpinning of emphasizing the magnitude of the shareholder’s holdings. The NPV technique channels resources to the right individuals with an emphasis of delivering customer satisfaction.

NPV compels managers to quantify after-tax cash benefits and cost giving the method one of its greatest strengths. Project managers have a duty to input accurate data to yield accurate forecasts.

The downside of the tool is that it fails to incorporate the effects of capital investments on earnings pre dividend. It also fails to predict long run competitive position and possible future market share. The NPV weakens lies in the fact that future streams of cash flows may have low NPVs despite applying traditionally regarded discounting rates.

Despite its indispensable role in determining the future value of the project since, it does not consider the interest rates and profitability accruing to the business during its lifespan.

The international rate of return

The IRR is an alternative to the NPV method. The IRR on the investment decision is the discount rate at which the NPV of the investment is zero. The investment criteria stipulate that the investment is feasible if and only if the IRR on the capital outlay is more than the cost of investment to the business. The technique boosts of the fact that it is the most used method of capital budgeting, and it takes into consideration all the factors of the interest rates as the profitability.

The decisions to either invest into a project will depend on the value of the calculated IRR. In case the IRR is greater than the value of the initial cost of the business, then the investor should undertake the investment. The method takes into considerations some many aspects of capital budgeting giving it an advantage over the other capital budgeting techniques. As an investment tool, it allows project managers to a have a glimpse of the financial outlook of the project in the long- run, handing them the privilege to make rational decisions about the future of the project. The technique has the sole advantage of allowing managers with minimal financial education to have a known how of the business prospects (Glann, 2009).

Despite this merits, the IRR portrays a few weakness in determining the future value of the project. The technique needs an estimate of the initial value of capital outlay; the use of estimates reduces the accuracy of the method. Similarly, the method does not provide the value-maxim sing decision when used to compare mutually exclusive projects. The IRR fails in situations in which the sign of the cash flow of the business often fluctuates during the lifetime of the project.

The payback period

The technique provides a less technical method of evaluating the future value of the project. The payback method accepts projects if the payback period of the business is less than a certain preset time (Kidwell and Parrino, 2009). The payback period in this case is the number of years the project will take to recover the initial capital outlay (Gitman, 2009). The method is very useful because of its simplicity and that it is a basic measure of the level of liquidity of the prospected business. Essentially, this method is useful in filtering projects and opens the path for the use of the other methods of determining the feasibility of the business using the other valuation techniques like the NPV and IRR.

However, the main setback of the methods lies in the fact it fails to explain the entire lifespan of the project whilst failing to show the total net worth of the business throughout its life span.

The profitability index

The technique is widely useful when evaluating capital budget. Mathematically, the index is the ratio of the payoff to investments of a project under consideration. The profitability index is crucial in ranking and making decisions when the value of capital has constraints (Peterson, 2008). Despite the merits, the measure fails in that it requires an estimate of the capital outlay of the business while it yields vague results when contrasting mutually exclusive decisions.