Behavioral considerations in capital budgeting

Of the four methods of analyzing a major purchase, which one is the best? While the payback period method and the accounting rate of return method are the easiest to compute, most accountants would prefer to look at the net present value and the internal rate of return. These methods take into consideration the greatest number of factors, and in particular, they are designed to allow for the time value of money. If the net present value is negative, or if the internal rate of return is less than the cost of borrowing, the project should be rejected as not financially feasible (unless the project is one that’s required by law, such as a safety upgrade).

Occasionally, when you’re looking at a number of projects that are competing for your time and money, the NPV and IRR methods will yield different answers to the question, “Which project is best?” Financial experts differ as to which method should be the deciding factor. Your accountant may be able to provide some insight as to which method is more useful in your particular situation.

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