Once we have identified the need for capital expenditure, various project options have to be examined and evaluated to select the most cost-effective one. This is important especially when there are various options but the capital available is limited. The different options may have different advantages, and their costs may also vary widely pending on the degree of advantage they offer. The option we prefer may not be the option we can afford. If capital is limited, it may have to be rationed and invested in several needy projects. This leaves us with little freedom to invest in any project that interests us. When evaluating the various project options, we first select the affordable options and then figure out which one of these we prefer.
A number of factors need to be analyzed before we select the project. For example, before we decide to buy a particular machine, a study should be made of the various brands of the same kind of machine available in the market along with the purchase terms of various suppliers. The contribution the machine would make to the business’s profit is another factor to consider.
It is best to use different criteria to evaluate the projects and to choose the one that satisfies most of them. This is because different criteria give different emphases to the various aspects of the project.
In any event, the choice of an alternative could be based on the estimated average annual profits the project would make during its useful life, and/or on the cash inflows estimated for each year of its useful life. The evaluation methods are thus categorized depending on whether or not we ignore the cash flows from the investment. Hence, we have a non-cash flow method and a cash flow method.
The non-cash flow method is an accounting rate of return method that expresses the accounting profit as a percentage of the initial investment. The methods that cash flows into account are further divided into non-discounted cash flow and discounted cash flow methods.
The non-discounted cash flow method is the payback period method which calculates the time required to recover the initial investment.
The discounted cash flow methods are:
• The net present value method, which compares cash outflow (considered negative) with the total of all present values of cash inflows (considered positive) to determine whether the difference (called the net present value) is positive or negative, the positive value being the acceptable one.
• The internal rate of return method, which determines a rate of interest by trial and error, when used to discount the cash inflows gives a total present value of cash inflows equal to the cash outflow. The higher the interest rate, the more acceptable the project will be.
• The discounted payback period method, where the cash flows used to calculate the payback period are first discounted at the required rate of return.