The toughest task and most important decision for financial managers is capital budgeting. The process of capital budgeting is used for the evaluation and selection of long-term investment that is required for achieving organizational goals. The process consists of decision-making about the use of assets, resources, principal and investments. According to Dayananda, capital budgeting is primarily concerned with how a firm makes decisions on sizable investment in long-lived projects to achieve the firms overall goal. This is the decision area of financial management that establishes criteria for investing resources in long-term real assets (Dayananda, 2002).
There are some techniques for capital budgeting, including Payback Rule, IRR, NPV, and the Profitability Index. They are used to make the decision-making easy for companies. In other words, capital budgeting techniques tell companies whether they should go for a project or investment or not. It happens often that different shareholders of a company have different opinions about selecting projects. For example, some are thinking about going to long-term growth and some are seeing towards projects that offer immediate surges in cash flow. Certainly, this would be a difficult situation for the company to decide what to do and satisfy all the shareholders. In this type of situation, the techniques of Payback Rule, IRR, NPV, and the Profitability Index play an important role. All these techniques are very useful, but they have their own strength and weaknesses and in this we will discuss which capital budgeting technique is superior to the rest and why.
Payback Rule the payback rule is used to show how much time a company will require to recover the cost of investment. This technique specifies a certain number of periods as a cutoff for deciding whether to invest in a project or not. Any investment project in which the initial investment cannot be recovered in particular cutoff time period is not considered good under the payback rule no matter what they provide past the cutoff. Payback rule is the simplest technique to use. This rule is explained as the time until the sum of estimated future cash flows equals the investment cost. Cash flows in this estimation can be either discounted or undiscounted. Considering the time value of money does not come under the payback rule. The recovery of a projects initial cost in a specific time is the payback period. Providing information on the risk of the investment and a crude measure of liquidity are considered advantages of payback rule. Payback rules ignoring of the time value of money and the risk of future cash flows come under its disadvantages.
IRR the IRR can be described as any discount rate that result in a net present value of zero. It has been the de facto standard of business for a long time. The IRR is generally taken as the expected return generated by the investment over periods. Because IRR is expressed in percentages verses dollar amount it is considered one of the simplest techniques of capital budgeting. This is an advantage of this technique. However, IRR also has some drawbacks. For example, it should not be used in mutually exclusive projects. IRR is also not recommended for projects that begin with an initial positive cash inflow.
NPV the NPV is the sum of present values of the individual cash flow which is used for analyzing the profitability of a project. The objective of every company is to maximize its shareholder value and for achieving this objective it is necessary for the company to take only those projects which could result in a positive NPV. By the use of NPV as a measure the company will select those projects that will increase its value. Selecting NPV as a technique for choosing investment assumes good capital markets so that the company has access to whatever capital is required to follow the positive NPV projects. Considering all the cash flows and the time value of money are NPVs advantages, while requiring an estimate of the cost of capital for calculation and expressing in terms of dollars, not as a percentage are its disadvantages
Profitability Index the capital budgeting technique of profitability index is an index which by the use of calculated ratio works to identify the connection between the costs and benefits of a proposed project. A ratio of 1.0 is the lowest appropriate measure on the index. In case, a project has value lower than 1.0, the profitability index would indicate that the projects present value is less than the initial investment. The increase in the profitability index will show that the project is going to improve its attraction. Profitability index is good in adjusting capital rationing and this is considered as an advantage of this technique. On the other hand, if projects are mutually exclusive and the company is not accepting fractions of projects, the situation will lead to a scaling problem with this method and certainly this is considered as a disadvantage of profitability index.
Example of capital budgeting techniques
NPV
What would the NPV for a project with a net investment of $40,000 and the following net cash flows be if the firms cost of capital is 5%? NCF's for year one is $25,000, for year two is $36,000 and for year three is $5000.
Net Discounted
Yr Cash Flows x PVIF@5% Cash Flows
1 $25,000 .952 $23,800
2 $36,000 .907 $32,652
3 $5,000 .864 $4,320
Total Discounted Cash Flows Discounted at 5% $60,772
Less: Net Investment $40,000
Net Present Value $20,772
Payback Period
If a project cost $100,000 and was expected to return $20,000 annually, the payback period would be $100,000 / $20,000, or 5 years.
Which capital budgeting technique is superior and why
In my opinion NVP is superior to the rest because it is best technique for evaluating projects or investments for a company. The NPV technique consists of discounting future returns to selection in recognition of the time value of money. That is, consideration of the discount factor makes able companies to estimate what the value of X dollars at the present time will be at a future time, given a return through available investment instruments equal to the at present prevailing interest rates.
NVP is superior to IRR because it has a lot of advantages as compared to IRR. It is impossible to use IRR in a situation where sign of the cash flows of projects are kept changing during the period of the project. NVP can be helpful in this situation. However, IRR is considered as a suitable alternative to NPV because it gives the discount rate at which investment has a 0 NPV.
Because NVP considers the time value of money it is superior to payback rule which does not consider cash flows beyond the discounted payback period. Also, the payback is not able to give a criterion that could indicate whether the investment increases the companys value. NPV is helpful also in this situation.
The reason that profitability index is less advantageous as compared to NVP is that it does not consider strategic value of projects. Unlike NVP, profitability index does not provide a correct decision when it is used to compare mutually exclusive projects.
In conclusion, it can be said that the capability for the management to assist in finding whether projects or investments should be given approval will always be a calculated risk. However, with techniques the risk can be lowered. Managers must learn to select which capital budgeting techniques is suitable in a particular situation.
