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Ask Milan Vaishnav Your Own Question

Milan Vaishnav
Milan Vaishnav, Financial Advisor
Category: Finance
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Experience:  Technical Analyst in Financial Markets -- Experience of more than 10 years in consulting
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What is capital planning Why is the internal rate of return

Customer Question

What is capital planning?

Why is the internal rate of return important to an organization?


Why is net present value important to a project?



How would you select from multiple projects presented to your organization?
Submitted: 5 years ago.
Category: Finance
Expert:  Milan Vaishnav replied 5 years ago.

Dear Friend,

 

Capital Planning, also known as Capital budgeting, (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

 

The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR)".

 

The importance of IRR is to an organisation is guaged from its importance in measuring Financial Efficiency of the Organisation.

 

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.

 

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.

 

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. It is calculated in the following manner :

graphic

 

NPV, is expremely important to a project. it is used to planning capital investment. It is used in Capital Planning in analyzing the Profitablity of the Investment in the Project.

 

In selecting from the multiple projects presented is concerned, some factors would have to be determined before selecting the project. After complete Capital Planning and Budgeting is done, we must select the project where the IRR is also high along with the NPV of the project and they are directly proportional to each other.

 

References:

http://www.investopedia.com/terms/n/npv.asp

http://en.wikipedia.org/wiki/Capital_planning#Net_present_value

http://74.125.153.132/search?q=cache:c6uEbiJEQZAJ:www.stpt.usf.edu/cob/documents/Finance_03-04.doc+importance+of+NPV&cd=7&hl=en&ct=clnk&gl=in

http://ces.iisc.ernet.in/hpg/envis/ratdoc95.html

http://74.125.153.132/search?q=cache:NFZP-7-lkFoJ:www.e-learningguru.com/tools/irr.xls+internal+rate+of+return+important&cd=9&hl=en&ct=clnk&gl=in

 

I hope the above helps,

Regards,

 

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