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Popular Methods of Capital Budgeting

written by: •edited by: Jean Scheid•updated: 4/2/2011

The management of an enterprise will have a choice between various capital projects that they could engage in, and need to employ a capital budget method to assist in their decision. Methods for a capital budget include the calculation of the project's net present value or internal rate of return.

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    The Need for Capital Budgeting

    The managers of an enterprise are responsible for increasing shareholder value and they need to evaluate projects on this basis. However, at any particular time, management will be faced with a number of potential capital projects and need to find some reliable criteria to assess the most suitable projects for the enterprise. This necessity to reliably evaluate projects and select the most suitable is the reason why various capital budget methods have been devised to assist management with their capital budgeting decisions.

    The types of project that an enterprise might engage in may differ from each other in many important respects such as the size of the initial outlay of funds, the length of the project and the time at which earnings (or cost savings) will arise from the project. The benefits from a project may arise in different ways and for some projects the cash flow will be more predictable than for others.

    Capital Equipment Certain projects are concerned with achieving greater efficiency and reducing costs, so the benefits will not be seen directly through cash inflows but will be seen in reduced cash outflows in the future. The purchase of more efficient machinery or software would come into this category. Another capital budgeting decision might involve a major expansion of the business, such as opening a new factory or opening up a distribution operation in a new market. Other capital budgeting decisions are concerned with the replacement and updating of equipment. Examples of this type of decision are the selection of a new model of a machine to purchase, the decision to lease or buy equipment or the decision to postpone the replacement of certain plant.

    The needs and preferences of different enterprises and different shareholders in an enterprise may also differ and this could complicate the capital budgeting decision. Management must determine if the best type of project for the enterprise to engage in is one which increases the long term value of the enterprise, or one which increases earnings in the short term. Although a number of different methods exist for evaluating projects, the ultimate choice of which projects to pursue is a matter of judgment for the management rather than an inevitable consequence of applying the capital budgeting methods. The application of certain popular capital budget methods does, however, increase the information available to management and enable them to arrive at a decision.

    Many projects will be accepted by management if they exceed a certain predetermined minimum rate of return, that may be based on the enterprise's cost of capital. These are referred to as screening decisions because projects are matched against a certain standard and are accepted if they meet that standard. Other capital budgeting decisions, for example the replacement of equipment, may involve the selection of one course of action from a number of possible alternatives. These are referred to as preference decisions because the alternatives are compared and the preferred project is selected. Various capital budget methods are used by management to evaluate and select projects.

    Please continue to Page 2 for more on capital budgeting methods.

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    The most popular capital budget methods include the payback method, the net present value and internal rate of return. Each capital budget method has strengths and weaknesses and management will choose the method that is most suitable in reflecting their requirements for selection of a project.
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    Payback Method

    The payback method is a capital budget method that provides a rough way of evaluating a project and is still sometimes used by managers in capital budgeting. This method looks at the length of time required by an investment to pay for itself, in other words the time that will elapse before the cash inflows equal the initial cash outflow. This period, known as the payback period, can be found by dividing the initial investment by the net annual cash inflow during the project.

    The payback period would need to be within a certain maximum length for the project to be accepted, and the shorter the payback period, the more the investment would be favored by management. Clearly this method has its drawbacks, one of the most serious being that it does not attempt to measure the profitability of the project and does not give enough consideration to the cash inflows or outflows occurring after the payback period is over. One project may have a longer payback period than another but may continue yielding earnings for many more years into the future, however the payback method does not take this into account. The payback method also does not take into account the time value of money and does not therefore apply any discount rate to cash inflows in future periods.

    To overcome some of these difficulties, a method known as the discounted payback period is also used. This method recognizes the time value of money by applying a discount rate such as the enterprise's cost of capital to the future cash flows. A cash flow that is to be received in two years' time would, therefore, be discounted when included in the calculation of the payback period, with the result that this period is normally longer than it would be under the payback method. It is still the case, however, that a project with a longer payback period than another may continue to generate cash inflows for much longer into the future, and the discounted payback period would not allow for these much greater aggregate cash inflows.

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    Net Present Value and Internal Rate of Return

    Capital Budget The use of the net present value method involves a comparison of the present value of the project outflows with the net present value of the inflows. The result of this comparison is the net present value of the project, which is used by management in the process of evaluating the project. The discount rate applied to future cash flows would be determined by the enterprise's cost of capital, this being the average rate of return that the enterprise needs to pay to its long-term loan creditors and shareholders for the loan and equity capital they have supplied to the enterprise. Where the cost of capital is used as a discount rate, any project with a negative net present value would need to be rejected as it would not earn a sufficient return to cover the return to the suppliers of the enterprise's capital. Where there is a positive net present value, this indicates that net inflows are worth more than net outflows, and this may indicate to management that the project should be accepted.

    Another capital budgeting method is to compute the internal rate of return of the project, which equates to the discount rate that would need to be used to arrive at a result where the cash inflows are equal to the cash outflows. Having found the project's internal rate of return, the management of the enterprise would compare this rate to the enterprise's minimum required rate of return from projects.

    As noted above, the minimum required rate of return could not be lower than the company's cost of capital. The internal rate of return is, therefore, used as a method of screening projects, by comparison of the internal rate of return to the minimum required rate of return on projects. A problem management may encounter if looking at the internal rate of return, is that it is not so useful where there are irregular cash flows in a project, with cash outflows at various points during the project and irregular cash inflows. This difficulty might be overcome if the project can be divided into various phases and an internal rate of return computed for each phase, however, management may find that where there are irregular cash flows, the net present value method would be more suitable.

    Please continue to Page 3 for more methods used in capital budgets.

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    A capital budget methods are only as useful as the data used in performing the computations. If the forecast of future cash flows from a project is incorrect, no capital budget method can produce the correct answer. If the discount rate chosen by the enterprise is incorrect, the net present value computed in relation to a project will be meaningless.
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    Other Capital Budgeting Methods

    A variant on the net present value method is the use of the profitability index, which looks at the present value of the future cash flows from the project (after the initial investment) and then divides this by the amount of the initial investment. This method looks at similar data to that produced for the net present value method but expresses this data in a different way.

    Payback Period A rather different capital budget method is the simple rate of return method, or accounting rate of return. This method looks at the net operating income from the investment, by deducting the project expenses from the estimated revenues. The method does not look at the cash flows but at the actual accounting income and expenses in computing the rate of return, so it includes for example the depreciation on fixed assets used in the project.

    Although this method attempts to accurately measure the accounting return from the project, it does not make any allowance for the time value of money by discounting future income or expenses. This means that income and expenses that are some years in the future are given the same weight as income and expenses in the first year of the project, and this may lead to misleading conclusions about the viability of a project. Owing to this weakness, the simple rate of return method is not very suitable for comparing different projects with different cash flow patterns.

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    Using Capital Budgeting Methods

    When selecting one or more capital budget methods for evaluating projects, management needs to be aware the information may be obtained from the use of a method is only useful if the data to which the method is applied is accurate. The most important factor in making a correct capital budgeting decision is to ensure as far as possible that the forecasts of cash flows or income and expenses from the project are made carefully and accurately, using all available information. The same applies to the choice of a discount rate when computing the net present value. Where inaccurate cash flow forecasts are made and the incorrect discount rate is used, the information provided by the use of a capital budget method may be useless to management, and may lead to an incorrect budgeting decision.

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    References

    "Capital budgeting" on netMBA - retrieved at http://www.netmba.com/finance/capital/budgeting/

    "Capital budgeting decisions" on Accounting for Management - retrieved at http://www.accountingformanagement.com/capital_budgeting_decisions.htm

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