Capital Budgeting: NPV and IRR Analysis

Running head: BUSINESS FINANCE
Business finance
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1BUSINESS FINANCE
Capital budgeting is considered as the procedure to determine the vitality of long-term
investment projects for purchasing or replacing the fixed assets like plant, property and
equipment or other projects. Different methods are used to determine the project’s feasibility
where capital investments are involved. Analysis of the capital investment projects are
considered as the most crucial task of the financial manager. It is crucially important to
undertake and accept the viable investment for long term growth of the entity as well as for
creating shareholder’s wealth. Widely used tools for analysing the feasibility of the project is
NPV (Net present value) and IRR (internal rate of return). NPV is potential change in the
wealth of an investor taking into consideration the time value of money (Hayward et al.,
2017). It is equal to the net cash inflows during the lifetime of the project reduced by the
initial outlay. This method is considered as one of the most consistent method used under
capital budgeting as it considers the time value of money through using the discounted cash
flow. Project is accepted if the NPV is positive and not accepted if the NPV is negative. On
the other hand, IRR is considered as the discount rate at which NPV of the project is nil. To
be more specific, IRR is discount rate that equates PV of future cash flows of project with the
initial outlay. Project is taken up if the IRR is more than the targeted IRR or more than the
cost of capital of the entity. If 2 or more projects those are mutually exclusive are compared,
the project with highest IRR is generally accepted (Winfree et al., 2018).
Sensitivity analysis that is also known as what-if analysis in capital budgeting refers
to procedure of pulling 1 key driver or input in the financial model and analysing how
sensitive it is to the change in the variable. It is used for improving the reliability and
accuracy of the cash flows. It needs analysis of sensitivity of different variables with changes
in any other variable. Primary objective of the sensitivity analysis is not quantifying the risk
but establishing how the NPV and IRR is sensitive to the changes in value of the key
variables while evaluating the investment projects. Generally, only the adverse changes are