Capital budgeting methods
- Defining capital budgeting.
- Capital budgeting methods.
- Net Present Value (NPV).
- Regular payback period.
- Discounted payback period.
- Internal Rate of Return (IRR).
- Net Present Value (NPV) shortcomings.
- Regular Payback period shortcomings.
Capital budgeting is concerned with the process of producing, evaluating, selecting and controlling capital expenditures. In this context, capital budgeting decisions are critical. Winning projects typically produce positive cash flows for a long period of time, while failing projects do not return enough cash flow to justify the investment.
Capital budgeting methods facilitate project undertaking and ensure ? to a certain extent ? the viability of the organization. On the other hand, the methods of capital budgeting are challenged in regards to the accuracy of the estimates they produce.
This paper discusses capital budgeting methods. Focusing on the analysis of net present value (NPV), regular payback period, discounted payback period and internal rate of return (IRR), the paper identifies shortcomings on NPV and regular payback period methods. These shortcomings are the result of ignoring the time value of money, the cost of debt and equity and the importance of time in regards to better informed decision making.
Keywords: capital budgeting, net present value, payback period, project evaluation
[...] NPV is a measure of profitability, which does not take into consideration the safety margin inherent in the cash flow forecasts or the amount of capital at risk. Therefore, if a project has NPV < 0 and there is a market alternative of equal risk profile, then the project will be rejected, but this doesn't necessarily mean that the project is worthless. Undertaking a project is not a now-or-never, accept/reject decision. There are cases that NPV calculations produce a positive value, but managers cannot find any reason to justify this positive NPV. [...]
[...] The regular payback period is a commonly used capital budgeting tool in the analysis of capital projects. The method identifies the payback year in which the cumulative cash inflows exceed the initial cash outflows, i.e. the cumulative cash flow is positive. To illustrate how the regular payback period is calculated, we assume Project A and Project B with the following expected net cash flows: Expected net cash flows Year Project A Project B The equation to calculate the payback period is: Payback Period = Year before full recovery + (cumulative net cash flow / net cash flow of year of full recovery) Project A Year Project A Project B The equation to calculate the discounted payback period is: Discounted Payback Period = Year before full recovery + (cumulative discounted net cash flow / discounted net cash flow of year of full recovery) Project A cash flows Discounted payback period for project A = 2 + ( 214.88 / 225.39 ) = 2.95 years Project B cash flows ) Discounted payback period for project B = 3 + ( 360.63 / 409.81 ) = 3.88 years On this basis, project A should be undertaken, as the shorter the payback period, the better the investment. [...]
[...] The key methods used to decide if a project should be undertaken or rejected are net present value regular payback period, discounted payback period and internal rate of return (IRR). However, as cash flow estimation is not straightforward as market realities are constantly changing, NPV and regular payback period method present certain shortcomings, which are the result of ignoring the time value of money, the cost of debt and equity and the importance of time in regards to better informed decision making. [...]