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As capital projects require huge investment and it is not possible to revert the decision once taken, because the consequences are severe, for example you can not say no to a construction in its middle stage or you can not say to supplier of machinery to get it back once they have been shipped, therefore the capital projects should be executed after thorough evaluation. There are four basic methods are available, they are Return on original investment, payback period method, net present value method and internal rate of return
method. But the most effective is the net present value as other methods do have some drawbacks, due to which they can not be use.
Return on original investment is based on average profit after tax over the life of the projects, therefore it ignores cash flow. It also does not consider time value of money. Payback period considers cash flow after tax but does not time value of money, even if time value of money is adjusted by using discounted pay back period method but it does not consider cash flow after payback period over the life of the project. Internal rate of return is near to net present value method but it ignores size of the investment as it is presented in terms of percentage therefore the amount of initial outlay is ignored.
Net present value is widely used. It is the difference between present value of inflows and present value of outflows, if present value of inflow is bigger it is called positive net present value and if present value of outflow is bigger it is called negative net present value. A project is rejected if it has negative net present value. But if there are two projects and they are mutually exclusive then the project with higher present value is going to be selected. If the projects are not mutually exclusive then NPV index or Profitability index is used to decide about a project.