Capital budgeting decisions are the most important investment decisions made by management. The objective of these decisions is to select investments in real assets that will increase the value of the firm. (Kidwell and Parrino, 2009) Capital budgeting techniques help management systematically analyze potential business opportunities in order to decide which are worth undertaking. (Kidwell and Parrino, 2009) There are many techniques used in the process of capital budgeting. The most common methods are payback, discounted payback period, net present value (NPV), internal rate of return (IRR), accounting rate of return (ARR), and modified internal rate of return (MIRR). This paper will examine each of these techniques, weighing the pros and cons of each, and determining which technique in correct in theory.

Payback Period

The payback period is not a sophisticated capital budgeting technique. With using the payback period for evaluating projects, a project is accepted if the payback period is below a special threshold. (Kidwell and Parrino, 2009) The payback period is defined as the number of years that it will take a project to recover the initial investment of a company. This period can be easily calculated by adding the years before cost recovery to the remaining cost to recover divided by the cash flow during the year.

It is because of the simplicity of this method is the most widely preferred tool for evaluating capital projects. Outside of its simplicity, the payback method provides a basic measure of the liquidity of the project. This is a great advantage to a company because it enables managers to assess the project in a way that, it shows that the more quickly the cash is recovered the less risky the project.

Although the payback period provides these advantages, it does present a few setbacks for management when evaluating a capital project. The payback period is a number which tells management a little about the beginning of the project, but little to nothing about the entire life of the project because, the payback method does not take into consideration cash flows after the payback period. (Glann, 2009) Also, the payback method does not show how the investment will increase the value of the company. And, this is the ultimate goal of accepting a capital project. Also, because the payback method is so simplistic it can promote carelessness on the part of management and it also does not take into consideration other factors that must be considered when evaluating a capital project, such as time value of money. (Glann, 2009)

Even though the payback period presents these setbacks to management, it can be used as a way of filtering projects. Should, the payback method show that the project should be accepted, management can go on to a more in depth evaluation using another capital budgeting method, such as NPV or IRR to determine if the project should be accepted. If a capital project is not accepted in accordance with the payback period method, than there is a good chance that the project should not be considered for other capital budgeting methods and should not be accepted.

Discounted Payback Period

As stated above, one of the disadvantages of the payback method is that it does not take into consideration time value of money. Because, the payback method is so simplistic many managers use a modified version called the discounted payback period. The calculation is similar to that of the original payback period except that the future cash flows are discounted by the cost of capital. (Kidwell & Parrino, 2009) Also, unlike the original payback period, the discounted payback period takes into consideration time value of money.

Even though, the discounted payback period corrects a few of the flaws of the original payback period it still has many of the same disadvantages that make it a rarely used technique. Like that of the original payback period, the discounted payback period does not take into consideration cash flows beyond the cutoff period. It also, does not show how the capital project will increase the value of the company.

Net Present Value Method (NPV)

Unlike the payback period method and the discounted payback period method, the net present value method is a sophisticated capital budgeting method because it considers time value of money. Because it considers time value of money, everything is calculated using today’s dollars. The NPV method gives a more realistic solution due to the fact that it takes into consideration that the firm reinvests intermediate cash flows at the company’s cost of capital rate, rather than the high rate specified by the IRR method. (Glann, 2009) NPV can be calculated by subtracting the present value of the cost of the project from the present value of the projects future cash flows. The capital project would then be accepted or rejected on the basis of the NPV being either greater than or less than $0. In the event that the NPV is greater than $0, the project should be accepted. NPV offers many advantages to managers. NPV enables managers to evaluate how the project will increase the value of the company. Also, it considers future cash flows and the riskiness of future cash flows. (Peterson-Drake, 2008)

Although NPV is a great capital budgeting tool, it is not as insightful as IRR because it doesn’t take into consideration the interest rates, profitability, and other benefits relative to the amount invested. This is a major setback for NPV because most managers want to see results measured in annual rate of return, like that of IRR. (Glann, 2009)

Internal Rate of Return Method (IRR)

The internal rate of return method is the most used method of capital budgeting and because it takes into consideration all of the aspects of NPV as well as interest rate, profitability, and other benefits relative to the amount invested, it is also considered a sophisticated capital budgeting method. IRR however, is the most complicated method of capital budgeting that is used to date and it is more efficient to use a scientific calculator or a spreadsheet formula to calculate IRR. (Anonymous, 2009) The decision to accept or reject a project would then be based on if the IRR is greater than or less than the cost of capital. In the event that the IRR be greater than the cost of capital, than the project should be accepted. Because IRR is the most difficult to calculate it takes managers a substantial amount of time to calculate versus NPV or Payback. Because IRR takes into consideration so many factors of the capital project, it has substantial advantage over the other capital budgeting methods. It allows managers to have a better outlook on the long run of the project and allow them to make a more substantial decision on a capital project. Also, the IRR method makes it easy for those managers that do not have a background in finance. (Glann, 2009) IRR has all of the advantages of NPV.

In contrast to this, IRR does offer a few significant disadvantages that must be taken into consideration when choosing whether to utilize this method. These disadvantages are:

1. Requires an estimate of the cost of capital

2. May not give the value-maximizing decision when used to compare mutually exclusive projects.

3. May not give the value-maximizing decision when used to choose projects when there is capital rationing.

4. Cannot be used in situations in which the sign of the cash flows of a project change more than once during a projects life. (Petersen-Drake, 2008)

Although IRR poses these setbacks, it is the most commonly used technique for evaluating capital projects because it allows managers to get a much more in depth look at the benefits of the project.

Accounting Rate of Return (ARR)

The accounting rate of return, sometimes called the book value rate of return, computes the return on a capital project using account number—the projects net income and book value—rather than cash flow data. (Kidwell & Parrino, 2009) ARR can be calculated by dividing the average net income by the average book value. ARR is fairly easy to calculate, but presents a significant number of setbacks when evaluating a capital project. Like that of the payback method, the ARR method does not factor in time value of money. Also, like that of the payback method, with ARR there is no economic rationale that links a particular acceptance criterion to the goal of maximizing stockholder value. (Kidwell & Parrino, 2009) Also, because ARR uses net income instead of cash flows, this limits the accuracy of the assessment of the project. It is because of these major disadvantages that ARR is not recommended for the evaluation of capital projects.

Modified Internal Rate of Return (MIRR)

In comparison with NPV, IRR displays a major disadvantage in regards to the rate at which the cash flows that are generated are reinvested. The NPV method assumes that cash flow from projects is reinvested at the cost of capital, where as the IRR method assumes cash flows are reinvested at the IRR. In the modified internal rate of return method, the cash flows are converted to future value at the end of the project life, compounded at the cost of capital. The values are then summed up to get the projects terminal value (Gitman, 2009) In order to calculate MIRR, the projects terminal value is divided by (1 + MIRR)^n. (Kidwell & Parrino, 2009) MIRR has the same advantages and disadvantages of IRR, except for one disadvantage. Unlike IRR, MIRR can be used in situations in which the sign of the cash flows of a project change more than once during a projects life.

Profitability Index

The profitability index is also a capital budgeting technique that is sometimes used by management when evaluating a capital project. The profitability index is the ratio of payoff to investment of a proposed project. The advantages of this method are the same as those of NPV or IRR, but the profitability index does offer an advantage that the other techniques do not offer. Unlike the other methods, the profitability index is useful in ranking and selecting projects when capital is rationed. (Peterson-Drake, 2008)

The profitability index poses a lot of advantages in comparison to other methods, but like all of the other methods it has its disadvantages. The disadvantages to the profitability index are:

1. Requires an estimate of the cost of capital in order to calculate the profitability index

2. May not give the correct decisions when used to compare mutually exclusive projects.

Using the profitability index may not offer as many disadvantages as the other methods, but it is not widely used by companies because it is only effective when used in comparing similar projects.

The Capital Budgeting At Work (Accept or Reject a Project)

Many organizations use a combination of techniques to decide whether to accept or reject a project. Let’s assume that the company uses Payback period, NPV, and IRR to makes these decisions. For example, let’s assume that the initial investment in a project is $850,000. The cash inflows for the first three years are $300,000, $400,000, and $250,000 respectively. The cutoff for this project is 5 years. The payback period would be:

PB=Years before recovery cost + (remaining cost to recover/cash flow during the year)

PB=2+ (850,000-700,000)/250,000

PB=2+150,000/250,000

PB=2+.60

PB=2.60 years

Because the cutoff is 5 years, and the payback is 2.60 years, the company would then filter the project thru to the NPV method and IRR method. When using the NPV method, the criteria for accepting or rejecting a project is based on whether NPV is greater than or less than $0. If the NPV is greater than $0, it is recommended that the project be accepted according to NPV. But, before a decision should be made, the company should examine the project using IRR. When using the IRR method, the criteria for accepting or rejecting a project is based on whether the IRR is greater than or less than the cost of capital. If the IRR is greater than the cost of capital, then the final recommendation would be to move forward with the project.

Conclusion

Capital budgeting is an important tool for managers in evaluating a potential investment that could prove to be beneficial to the company. All companies are looking to minimize cost and maximize value in the most effective way possible. And, through capital budgeting techniques, the managers are given the tools that are needed to make efficient decisions on capital projects. When a company is looking to make a major purchase of equipment or machinery, capital budgeting is used to determine which option would be a better investment.

There are many capital budgeting techniques that managers can use. But, when weighing the advantages and disadvantages of each technique, it is, in my opinion, that the modified internal rate of return method is the best technique to use when determining whether to accept or reject a project. Unlike, IRR or NPV, MIRR gives a more concise and realistic look at each project. Because MIRR uses the cost of capital instead of the IRR, the MIRR better reflects the rate at which the companies are likely to earn on each project. (Kidwell & Parrino, 2009) Using IRR may portray an unrealistic view of each capital project, and could cause the company to make the wrong decision in investing in a project. Although, it is evident that the MIRR method is the best method to use theoretically, most companies do not use this method. Most companies, uses a variety of different capital budgeting techniques because they have may different types of projects to consider.