Capital budgeting techniques:
There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the Payback Period, Discounted Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.
Payback Period:
A simple method of capital budgeting is the Payback Period. It represents the amount of time required for the cash flows generated by the investment to repay the cost of the original investment. For example, assume that an investment of $600 will generate annual cash flows of $100 per year for 10 years. The number of years required to recoup the investment is six years.
Each requires an initial $1,000 investment. But each project varies in the size and number of cash flows generated. However, Project A generates the most return ($2,500) of the three projects. Project C, with the shortest Payback Period, generates the least return ($1,500).
Thus, the Payback Period method is most useful for comparing projects with nearly equal lives.
Discounted Payback Period:
The Payback Period analysis does not take into account the time value of money. To correct for this deficiency, the Discounted Payback Period method was created.
For example, it takes 3.54 years rather than 2.86 years (.68 of a year longer) to repay the investment in Project B.
It takes longer to repay the investment when the cash flows are discounted.
Net Present Value:
A positive (negative) Net Present Value means that the rate of return on the capital investment is greater (less) than the discount rate used in the analysis.
If the five percent discount rate is used, the Net Present Value is positive and the project is accepted. If the 10 percent rate is used, the Net Present Value is negative and the project is rejected.
Profitability Index:
The Profitability Index is computed by dividing the present value of cash inflows of the capital investment by the present value of cash outflows of the capital investment. If the Profitability Index is greater than one, the capital investment is accepted. If it is less than one, the capital investment is rejected.
The Profitability Index is useful for comparing two or more projects which have very different magnitudes of cash flows.
Internal Rate of Return:
In other words, the Internal Rate of Return is the discount rate that makes the Net Present Value equal to zero.
Selection of capital budgeting technique:
Each of the capital budgeting methods outlined has advantages and disadvantages. The Payback Period is simple and shows the liquidity of the investment. But it doesn’t account for the time value of money or the value of cash flows received after the payback period. The Discounted Payback Period incorporates the time value of money but still doesn’t account for cash flows received after the payback period. The Net Present Value analysis provides a dollar denominated present value return from the investment.
However, it has little value for comparing investments of different size. The Profitability Index is a variation on the Net Present Value analysis that shows the cash return per dollar invested, which is valuable for comparing projects. However, many analysts prefer to see a percentage return on an investment. For this the Internal Rate of Return can be computed.
Discount rate vs interest rate:
The discount rate refers to the interest rate used to determine the present value. For example, $100 invested today in a savings scheme that offers a 10% interest rate will grow to $110.
Interest rates are the amount that a lender charges on the amount that they loan. In contrast, discount rates are the amount the Federal Reserve Banks charge financial institutions on overnight loans:
