Capital Budgeting Alternatives to NPV and IRR Analysis
The discounting cash flow methods of net present value and internal rate of return analysis are common for capital project analysis, but other methods exist.
- Economic Income: applies the same after tax cash flow analysis as NPV modeling, but adds an adjustment to account for the change in the market value of the asset.
- Accounting Income: this method represents the income that would be reported under local accounting regulations. Deprecation will reflect historic asset values (unlike economic income) and interest expense will be deducted rather than captured as part of the discounting of future cash flows.
- Economic Profit (EP) or Economic Value Added (EVA): this method takes net operating profit after tax (NOPAT) and makes a reduction based on the weighted average cost of capital (WACC). The following formula represent the EP/EVA method:
EP = EBIT (1 – tax rate) – WACC (capital invested)
- Residual Income (RI): similar to EP, RI starts with net income and deducts an equity charge to the prior accounting period’s book value of equity.
RI = Net Income t – (return required on common equity * BV Equity t-1)
The NPV of a project is equal to the sum of its residuals incomes discounted by the required return on common equity.
- Claims Valuation: this method is a similar to standard NPV modeling. Under the claims valuation method, the analyst discounts cash flows to the different claimants (debt holders versus equity holders) at their respective costs of capital.
