Methods of capital budgeting analysis that utilize discounted cash flow concepts are Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI). NPV can be used to determine the difference between the present value of all future cash inflows and the present value of all (the initial as well as all future) cash outflows, using the required rate of return. A project with a positive NPV is acceptable. The IRR is the discount rate at which the NPV of an investment will be equal to 0, or the discount rate at which the present value of the expected cash inflows from a project equals the present value of the expected cash outflows. If this rate is higher than the required rate of return, the investment is acceptable. The PI calculation is used to determine the ratio of the PV of net future cash flows (both inflows and outflows) to the amount of the initial investment. It is calculated as follows, using the same information from the NPV calculation: PV of future net cash flows ÷ Net Initial Investment. If a project has a positive net present value, the profitability index will be above 1.00 and it will be an acceptable project. However, none of these discounted cash flow methods can be used to determine the length of time required to recover the initial cash outlay of a capital project.
The Payback Method is used to determine the number of periods that must pass before the net after-tax cash inflows from the investment will equal (or "pay back") the initial investment cost. If the incoming cash flows are constant over the life of the project, the payback period may be calculated with a simple division as follows: Initial net investment ÷ Periodic constant expected cash flow. If the cash flows are not constant over the life of the project, we must add up the cash inflows and determine on a cumulative basis when the inflows equal the outflows.
A probability-weighted Net Present Value for a capital project cannot be used to determine the length of time required to recover the initial cash outlay of a capital project.
The Net Present Value method of capital budgeting analysis cannot be used to determine the length of time required to recover the initial cash outlay of the capital project.
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