Capital Budgeting Techniques Definition
Capital budgeting techniques are a long-term investment evaluation helping to identify the most positive value to a company. It helps a company identify the risks and benefits of investing in a project.
Although capital budgeting is a great way to provide solutions in a firm’s decision-making, numerous advantages and disadvantages come with the different capital budgeting techniques.
Capital budgeting techniques are accounting rate of return, internal rate of return, modified internal rate of return, net present value, and payback period.
Capital Budgeting Techniques
1. Accounting Rate of Return
Accounting rate of return is a method of capital budgeting that uses accounting profits rather than cash flows to determine the profitability of long-term investments. The profits considered in this method are after-tax profits.
ARR clearly shows the percentage rate of return expected on a project compared to the initial investment costs. The ARR of a project is determined by dividing the average annual profits by the average investments multiplied by 100%. It is given as follows;
| ARR = Average Annual Profits ÷ Average Investment * 100 |
Where to use ARR
The accounting rate of return is used to compare multiple projects and determine the expected return rate for each.
ARR decision rule
In the event of two mutually exclusive projects, accept the project with the highest accounting rate of return.
In the event of a single project, then consider the arbitrary tax.
Advantages of ARR
One of the advantages of using an accounting rate of return is that it considers all annual expenses, including the depreciation involved with the project.
Another advantage is its simplicity in the calculation. The formula of ARR is simple to use and determine a project’s rate of return.
It is also very reliable when management needs to decide quickly without considering the payment schedule or payback period.
Disadvantages of ARR
One of the main disadvantages of the accounting rate of return is it does not consider the time value of money. The time value of money compares the value of money now and in the future.
2. Internal Rate of Return
The internal rate of return, or IRR, is the rate of return that gives a zero net present value. IRR is calculated by the trial and error method, where there are two sets of discounted rates. One gives a positive net present value, while the other gives a negative one.
In the calculation of the internal rate of return, the following steps are followed:
- Calculate the NPV of the project given the cost of capital.
- If the NPV calculated above is positive, recalculate the NPV of the project using a higher trial discounting rate to obtain a negative NPV.
- If the NPV obtained using the cost of capital was negative, then use a lower trial discounting rate to obtain a positive NPV and use the IRR formulae to calculate the IRR of the project.
IRR decision rule
If the IRR exceeds the opportunity cost of capital, then the management should accept the project.
When IRR is less than the opportunity cost of capital, then the management should reject the project.
If the IRR equals the opportunity cost of capital, the management will be indifferent.
3. Modified Internal Rate of Return
The modified internal rate of return is a capital budgeting method used to determine the returns of a project and then compare it with other projects. MIRR is more accurate than the internal rate of return because it considers the cost of capital as the reinvested rate for a business’s positive cash flow.
MIRR Formula
The modified internal rate of return is calculated by dividing the future value of the company’s positive cash flow by the present value of the company’s negative cash flow.
| MIRR = n√(FVCF ÷ PVCF) – 1 |
Where:
- FVCF is the future value of positive cash flows
- PVCF is the present value of negative cash flows
MIRR decision rule
The modified internal rate of return decision rule is similar to the internal rate of return decision rule. It states that management should accept the investment if its MIRR exceeds the project’s expected returns.
Advantages of MIRR
It is better and improved than the IRR and NPV. MIRR helps avoid any drawbacks that come with them.
It’s simple to calculate, measure investment probability to succeed, and rank different projects from most profitable to least profitable.
Disadvantages of MIRR
MIRR fails to quantify the effects of different investments on investors’ wealth. In addition, people with little to no financial background may find it challenging to understand.
4. Net Present Value
The net present value, commonly known as NPV, is the difference between the present value of cash flow inflow and the present value of cash flow outflow over an estimated period. In simple financial language, NPV is a way of calculating an individual return on investment.
Net present value is known for accounting for the time value of money. It uses a discounted cash flow calculation to determine the present value of future payments or receipts. NPV provides a number that a company can use to compare the initial outlay and the present value of the returns.
NPV Decision Rule
Management should only accept the project if the net present value is positive or >0. It is because the company will earn profits and proceed with the project.
Management should reject the project if the net present value is negative or <0. A negative NPV will result in losses for the company.
If the net present value is 0, the management should use an alternative method to evaluate the project.
Advantages of NPV
NPV considers the time value of money. It helps determine whether the amount invested in the current period is worth more in the future.
The other advantage is its simplicity in determining whether a project brings value, considering the firm’s capital cost and cash flows from a project, and its ability to rank projects.
Disadvantages of NPV
NPV is unable to set guidelines for setting a rate of return.
This technique only focuses on short-term projects, omission of high costs, and the inability to compare different size projects.
5. Payback Period
The payback period is the years it takes to recover the initial investments if the cash flow depicts an annuity pattern. It is a straightforward investment appraisal technique under the non-discounted cash flow technique.
Payback period is used by financial workers, investors, and firms to determine investment returns and risks. It is expressed in years and months, where the shorter the payback period, the more desirable the project will be. Conversely, the longer the payback period, the less attractive an investment will is.
Payback period decision rule
The project whose payback period is less than the acceptable payback period should be taken by management.
The management should reject the project whose payback period is longer than acceptable.
6. Profitability Index
The profitability index is the relative measure of a project’s profitability. It is calculated by dividing the present value of cash flow inflow by the investment’s initial outlay.
Profitability Index decision rule
The higher the project’s profitability index, the more attractive it is; the lower the profitability index, the less attractive a project is.
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