There are five methods to evaluate a capital budgeting decision. But someone should know all the methods to use them properly to evaluate any capital budgeting proposal. Keep these points in mind while selecting the proper evaluation method
Net Present Value (NPV) is the most widely used method to evaluate a capital budgeting decision. But it is not effective when the cash flow from the project is uncertain in future.
NPV process also does not take into consideration the net present value compared to the initial investment amount which sometime leads to wrong decisions. Suppose one project X requires initial investment of 1000 USD and NPV is 1000 USD and another project Y requires initial investment of 500 USD and NPV is 700 USD, as per the NPV method the project Y will be accepted and project X will be rejected if the management has to select any one of them.
Internal Rate of Return (IRR) is also used for most of the cases and it resolves the problems faced by the NPV process.
But if the project involves complex cash flows (cash outflows during the project duration as well), IRR method may provide two IRR methods which makes the result ambiguous and decision making tough.
Payback and Discounted payback methods are used when the future cash inflows are uncertain after some time and the liquidity is most important parameter.
The Profitability Index (PI) method use NPV to evaluate a capital budgeting process and removes the drawback of the NPV process as it uses the initial cash flow to compare the NPV generated.
Considering all the advantages and disadvantages, the appropriate method will be chosen based on the project type, duration and management requirement.