Capital Budgeting Methods for Corporate Project Selection

1798 Words Apr 10th, 2013 8 Pages
Capital Budgeting Methods for Corporate Project Selection In a 2001 Graham and Harvey survey of 392 chief financial officers (CFOs) asked “how frequently they used different capital budgeting methods?” Approximately 75% of the CFOs replied that they use net present value (NPV) or Internal Rate of Return (IRR) always or almost always (Smart, Megginson & Gitman, 2004, pg. 251). Projects are viewed as capital investments in the corporate world, and as such, are evaluated closely for their possible financial impacts on the “bottom line” due to their higher risk of failure. Capital investments are those that are considered long-term investments such as manufacturing plants, R&D, equipment, marketing campaign, etc., and capital …show more content…
236).
INTERNAL RATE OF RETURN
Internal rate of return (IRR) is rate of return that a firm expects to earn if it selects the project and holds it for its economic life. That rate of return is the discount rate that will make the NPV equal zero. This discount rate can be determined with a financial calculator, excel or trial and error. Once this rate is determined, it is then compared to a “hurdle rate” established by the firm. The “hurdle rate” should be set “at a level that reflects market returns on investments that are just as risky as the project under consideration” (Smart, Megginson & Gitman, 2004, pg. 238). The “hurdle rate” is the discount rate in most cases.
IRR, like NPV, takes the in to account the time value of money. This means that the first year cash flows are greater in value than the second year and so on for the economic life of a project. The second strength is that the “hurtle rate” can be based on market returns of similar projects. The last is that since it is a “rate of return”, it is more understandable to non-financial managers than NPV.
There are some mathematical “quirks” of IRR that should be noted. If the cash flows alternate between negative and positive values, it is possible to have multiple IRRs. In cases with borrowing and lending, it is

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