Which capital budgeting method is the best

Budgeting is a cash-based concept. There are three types of capital budgeting techniques to consider for your budgeting purposes. They are:. Payback method 2. Net present value method 3. Internal rate of return method. This is the simplest way to budget for a new asset.

The payback method is deciding how long it will take a company to pay off an asset. This capital budgeting scenario implies that the purchase can be paid off in 10 years. The quicker the payback period is, the quicker the company is able to recover the cost of the new piece of equipment. The index at the 10 percent discount rate returns only The Internal Rate of Return is the rate of return from the capital investment.

An Internal Rate of Return analysis for two investments is shown in Table 6. If the Internal Rate of Return e. However, if the company is choosing between projects, Project B will be chosen because it has a higher Internal Rate of Return. The Internal Rate of Return analysis is commonly used in business analysis. However, a precaution should be noted.

So, only the discounting from year three to the present time is relevant for the analysis Figure 2. For the Discounted Payback Period and the Net Present Value analysis, the discount rate the rate at which debt can be repaid or the potential rate of return received from an alternative investment is used for both the compounding and discounting analysis. Conversely, if the Internal Rate of Return is low, the company may be able to reinvest at a higher rate of return. So, a Reinvestment Rate of Return RRR needs to be used in the compounding period the rate at which debt can be repaid or the rate of return received from an alternative investment.

The Internal Rates of Return for the projects are 7. For a comparison of the six capital budgeting methods, two capital investments projects are presented in Table 8 for analysis. So if funds are limited, Project A will be chosen.

Alternatively, the company may accept projects based on a Threshold Rate of Return. When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management's preferences and selection criteria, more emphasis will be put on one approach over another.

Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods. The payback period calculates the length of time required to recoup the original investment. A short PB period is preferred as it indicates that the project would "pay for itself" within a smaller time frame.

In the following example, the PB period would be three and one-third of a year, or three years and four months. Payback periods are typically used when liquidity presents a major concern.

If a company only has a limited amount of funds, they might be able to only undertake one major project at a time. Therefore, management will heavily focus on recovering their initial investment in order to undertake subsequent projects. Another major advantage of using the PB is that it is easy to calculate once the cash flow forecasts have been established. There are drawbacks to using the PB metric to determine capital budgeting decisions.

Firstly, the payback period does not account for the time value of money TVM. Simply calculating the PB provides a metric that places the same emphasis on payments received in year one and year two. Such an error violates one of the fundamental principles of finance. Luckily, this problem can easily be amended by implementing a discounted payback period model. Basically, the discounted PB period factors in TVM and allows one to determine how long it takes for the investment to be recovered on a discounted cash flow basis.

Another drawback is that both payback periods and discounted payback periods ignore the cash flows that occur towards the end of a project's life, such as the salvage value. Thus, the PB is not a direct measure of profitability. There are other drawbacks to the payback method that include the possibility that cash investments might be needed at different stages of the project.

Also, the life of the asset that was purchased should be considered. If the asset's life does not extend much beyond the payback period, there might not be enough time to generate profits from the project. Since the payback period does not reflect the added value of a capital budgeting decision, it is usually considered the least relevant valuation approach.

However, if liquidity is a vital consideration, PB periods are of major importance. The internal rate of return or expected return on a project is the discount rate that would result in a net present value of zero. Since the NPV of a project is inversely correlated with the discount rate—if the discount rate increases then future cash flows become more uncertain and thus become worth less in value—the benchmark for IRR calculations is the actual rate used by the firm to discount after-tax cash flows.

An IRR which is higher than the weighted average cost of capital suggests that the capital project is a profitable endeavor and vice versa. The IRR rule is as follows:. You are free to use this image on your website, templates etc, Please provide us with an attribution link How to Provide Attribution?

It refers to the period in which the proposed project generates enough cash so that the initial investment is recovered. The project with the shorter payback period is selected. The formula of payback period is represented as below,. Options available are Product A and Product B, which are mutually exclusive Mutually Exclusive Mutually exclusive refers to those statistical events which cannot take place at the same time.

Thus, these events are entirely independent of one another, i. The expansion plan will increase output by 1, units for Product A and by 2, units for Product B. Thus the Incremental cash flow Incremental Cash Flow Incremental cash Flow is the additional cash inflow that a business might receive by acquiring a particular project.

In other words, it is basically the resulting increase in cash flow from operations due to the acceptance of new capital investment or a project. It is the most simple method. Hence it takes very less time, and effort is involved in arriving at a decision. The time value of money Time Value Of Money The Time Value of Money TVM principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.

Generally, Cash flows generated at the initial stage is better than cash flows received at the later stage. There might be two projects with the same payback period, but one project generates more cash flow in the early years.

Hence the decision taken by this method in this particular scenario will not be the most optimum one.