Capital Budgeting Techniques for Investment Decisions

Capital Budgeting refers to the planning procedures used for the determination of the fact that whether the long-term investments of the companies like buying of new machinery, replacement of machinery or others are worth cash funding with the help of capitalization structure. Capital Budgeting is an important aspect for the business organizations and thus, much research has been conducted on this particular topic. Some of them have similar findings and some of them have different.

According to Bennouna, Meredith and Marchant (2010), most of the business organizations prefer the use of Internal Rate of Return model as the most important as well as efficient model for making investment decisions. According to him, majority portion of the companies consider that the determination of the cash flow projections is the toughest stage in the process of capital budgeting. As per Lundholm and O’keefe (2001), the model of internal rate of return is the most preferred techniques for decision-making to the business organizations. He has stated that most of the companies stay concerned for the selection of capital budgeting techniques for investment decision-making process. Moreover, to the companies, the technique of present value is useful for the evaluation of the new product lines. However, in the opinion of Froot and Stein (1998), the model of discounted cash flow is the most popular technique of capital budgeting for the firms around the globe. In this context, he mentioned about the internal rate of return model for effective decision-making process. However, many firms are still using the model of payback period as a secondary approach for investment decision making.

According to the findings of Carr, Kolehmainen and Mitchell (2010), for the evaluation of capital budgeting projects, most of the companies use either Net Present Value or Internal Rate of Return model as their primary methods; and they also use payback period as secondary approach. As opined by Denison (2009), most of the large business corporations put emphasis on discounted cash flow models for their capital budgeting decision-making model and they heavily depend on payback period techniques for taking decisions in the smaller projects. As per the findings of Kester and Chang (1999), most of the large organizations in Hong Kong, Malaysia and Singapore prefer to use the model of Payback Period for the evaluation and rank the capital projects. He concluded that the discounted cash flow techniques are more popular among the companies as a primary technique for the evaluation of projects.

Accounting Rate of Return (ARR)

According to the findings of Okoruwa, Cox and Thompson, many small business organizations struggle while measuring and evaluating the capital projects. For this reason, they largely rely on the technique of payback method as a primary method to measure and evaluate their business projects. As the small companies take the business risks very seriously, their required rate of return for risky project tends to be very high. As opined by Drake (2006),  more than 75% companies in Canada employ discounted cash flow model for the assessment of their capital investments. He also mentioned that the companies use internal rate of return techniques more frequently than Net present value in the assessment of capital decisions. According to Adkins and Paxson (2014), most of the hundred-fortune companies use discounted cash flow model and for this reason, they use internal rate of return techniques more than net present value for the assessment of capital projects. As per Lilian Chan (2004), majority portion of the companies prefer to use net present value method for capital budget decision-making model.

In the process of capital budgeting, many techniques assist the organizational managers in the process of making decisions. The following discussion shows the description of some of these capital budgeting processes.

 One of such technique is Accounting Rate of Return (ARR). ARR refers to the proportion of annual net profit average to either the net investment or the average investment in the particular project.  ARR is expressed as Average Annual net profit / Initial investment or Average Investment. In most of the cases, ARR is calculated based on average investment rather than original investment. After the determination of ARR, it is compared with the desired rate of return. According to the rules, the project will be acceptable in case the calculated ARR is bigger than or equal to the desired rate of return. The next capital budgeting technique is called Payback Period (PBP). It refers to the required number of years for the recovery of initial investment by using net cash flow after tax. After the calculation of the PBP, a comparison is done between the PBP and minimum acceptable payback period that is selected arbitrarily (Hall 2012). According to the decision rule, the particular project will be accepted in case the PBP calculated is equal to or less than the selected desired period as it is better to recover the amount of initial investment in shorter time. Payback Period is expressed as Cash Outlay (Investment) / Annual Cash Inflow.

Payback Period (PBP)

The next important technique for capital budgeting is called Internal Rate of Return (IRR). IRR can be expressed as the discount rate for equaling the present value of the expected net cash inflows with an initial investment having net present value equal to zero. For selection, it is good to have higher IRR as projects having higher IRR become more profitable (Bhuller, Mogstad and Salvanes 2017). This method also considers as time value of money. It needs to be mentioned that it is tedious task to calculate the value of IRR. The next capital budgeting technique is called Profitability Index (PI) or Benefit-Cost Ratio. In the process of PI, the discounting method for future cash flows is done; after that, the process of adding up the present value is done. Then, all the present value sums are divided by the initial investment (Pasqual, Padilla and Jadotte 2013). According to the decision rule, managers should accept the project having PI of one or greater than one. PI is expressed as present value of cash inflows / initial cost outlay or net present value (benefits) / net present value (costs).

The last important techniques for capita budgeting is Net Present Value (NPV). NPV is considered as most preferred as well as most popular method for capital budgeting. The calculation of NPV is done by discounting the after tax future cash flows with the use of risk-adjusted cost of capital. After that, process of adding up the present values of future cash flows is done. According to the decision rule, capital projects having zero NPV or greater than zero will be accepted (Pasqual, Padilla and Jadotte 2013).

Years	Amount ($)
0	(300,000)
1	75,000
2	140,000
3	125,000
4	265,000
5	220,000
NPV	295399.90
IRR	37%

Table 1: Calculation of NPV and IRR

In the above hypothetical situation, $ 300,000 is invested in the initial year for a particular project. From this investment, the company received certain amount of cash inflows throughout the five years. It is assumed that the discount rate is 10%. After applying the formula of NPV and IRR, it can be observed that NPV is positive and IRR is greater than 10%. As per the rules of NPV, a project will be accepted when its NPV is positive. On the other hand, the rules of IRR states that a project will be accepted when the IRR will be more than the discount rate. Thus, it can be concluded that the project will be accepted from both the perspectives of NPV and IRR.

Internal Rate of Return (IRR)

The above discussion shows various techniques of capital budgeting. It needs to be mentioned that these techniques have their usefulness for the organizational managers in the context of wealth creation. Capital budgeting techniques help the organizational managers to set up long-term goals for the growth and prosperity of their businesses (Carr, Kolehmainen and Mitchell 2010). The ability of these techniques to appraise the investment projects helps in creating framework for firms to plan their long-term directions. In addition, with the assistance of the capital budgeting techniques, organizational manages can find new investment for their business organizations that is very mush helpful in the wealth creation of the companies. Most importantly, organizational managers can make the forecast and estimation of their future cash flows with the assistance of different techniques of capital budgeting. These aspects help the managers in taking decisions regarding the acceptance of certain capital projects (Adkins and Paxson 2014). At the time of the selection of the capital projects, organizational managers are required to take many decisions that require the timely flow of project information. Organizational managers can get all the necessary information about different capital projects from different capital budgeting techniques. One of the major aspects of wealth creation is to monitor and control expenditures. Capital budgeting techniques help to define the necessary expenditure for an investment project. Thus, the managers become able to identify the necessary expenses so that they can control them (Brunzell, Liljeblom and Vaihekoski 2013). Most importantly, the capital budgeting techniques assist the organizational managers in taking valuable decisions for their companies. Thus, the above discussion shows that the capital budgeting techniques have many important in the business organizations (Brief 2013). All these aspects help managers identify the aspects that are helpful for the companies in wealth creation. As a result of this, the managers are able to take decisions for wealth creation in the companies.

Conclusion

From the above discussion, it can be seen that there are many tetchiness for capital budgeting in the companies; they are IRR, NPV, PBP, PI and ARR. However, according to the trend of last ten years literature review on capital budgeting, it can be seen that most of the companies all over the world prefer to use two techniques as their primary capital investment decision-making technique; they are IRR and NPV. However, companies prefer to use the technique of PBP as their secondary techniques to appraise investment projects. Thus, it implies that IRR, NPV and PBP are the most popular techniques of capital budgeting. The above discussion also shows that these techniques of capital budgeting have major importance in increasing wealth in the companies. The capital budgeting techniques help the organizational managers in providing important information regarding various capital projects so that they can be helpful in wealth creation. In addition, these techniques assist the managers in setting long-term goals of their companies. Apart from this, the estimation and projection of future cash flows are two of the major contributions of capital budgeting techniques that lead to wealth creation.

References

Adkins, R. and Paxson, D., 2014. Stochastic equipment capital budgeting with technological progress. European Financial Management, 20(5), pp.1031-1049.

Bennouna, K., Meredith, G.G. and Marchant, T., 2010. Improved capital budgeting decision making: evidence from Canada. Management decision, 48(2), pp.225-247.

Bhuller, M., Mogstad, M. and Salvanes, K.G., 2017. Life-cycle earnings, education premiums, and internal rates of return. Journal of Labor Economics, 35(4), pp.993-1030.

Brunzell, T., Liljeblom, E. and Vaihekoski, M., 2013. Determinants of capital budgeting methods and hurdle rates in Nordic firms. Accounting & Finance, 53(1), pp.85-110.

Carr, C., Kolehmainen, K. and Mitchell, F., 2010. Strategic investment decision making practices: A contextual approach. Management Accounting Research, 21(3), pp.167-184.

Denison, C.A., 2009. Real options and escalation of commitment: A behavioral analysis of capital investment decisions. The accounting review, 84(1), pp.133-155.

Drake, P.P., Capital budgeting techniques. Online (datum poslední revize: 29.6. 2006): www. fau. edu/~ ppeter/fin3403/module6/capbudtech. pdf.

Froot, K.A. and Stein, J.C., 1998. Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach. Journal of financial economics, 47(1), pp.55-82.

Hall, J.H., 2012. An analysis of capital budgeting methods, the cost of capital and decision-makers in listed South African firms. Corporate Ownership & Control, 9(4), pp.381-390.

Kester, G.W. and Chang, R.P., 1999. CAPITAL BUDGETING PRACTICES IN THE ASIA-PACIFIC REGION: AUSTRALIA, HONG KONG, INDONESIA,… Financial Practice and Education, 9(1), pp.25-33.

Lilian Chan, Y.C., 2004. Use of capital budgeting techniques and an analytic approach to capital investment decisions in Canadian municipal governments. Public Budgeting & Finance, 24(2), pp.40-58.

Lundholm, R. and O’keefe, T., 2001. Reconciling value estimates from the discounted cash flow model and the residual income model. Contemporary Accounting Research, 18(2), pp.311-335.

Okoruwa, A., Cox, A.T. and Thompson, A.F., Three Treatments of Debt Financing for Capital Budgeting Decisions. Appraisal J, 62, pp.189-96.

Pasqual, J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability criteria with the net present value. International Journal of Production Economics, 142(1), pp.205-210.

Pasqual, J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability criteria with the net present value. International Journal of Production Economics, 142(1), pp.205-210