Capital budgeting is an important tool for leaders of a company when evaluating multiple opportunities for investment of the firm’s capital. Every company has both a limited amount of capital available and a desire to deploy that capital in the most effective way possible. When a company is looking at, for example, acquisitions of other companies, development of new lines of business or major purchases of plants or equipment, capital budgeting is the method used to determine whether one option is better than another. There are several capital budgeting methods, each with its pros and cons.
Capital Budgeting by Payback Period
The most-used method of capital budgeting is determining the payback period. The company establishes an acceptable amount of time in which a successful investment can repay the cost of capital to make it. Investment alternatives with too long a payback period are rejected. Investment alternatives inside the payback period are evaluated on the basis of the fastest payback.
Payback method disadvantages include that it does not account for the time value of money.
Net Present Value Capital Budgeting
In net present value capital budgeting, each of the competing alternatives for a firm’s capital is assigned a discount rate to help determine the value today of expected future returns. Stated another way, by determining the weighted average cost of capital over time, also called the discount rate, a company can estimate the value today of the expected cash flow from an investment of capital today. By comparing this net present value of two or more possible uses of capital, the opportunity with the highest net present value is the better alternative.
A disadvantage of the net present value method is the method's dependence on correctly determining the discount rate. That calculation is subject to many variables that must be estimated.
The Internal Rate of Return Method
An advantage of capital budgeting with the internal rate of return method is that the initial calculations are easier to perform and understand for company executives who may not have a financial background. Excel has an IRR calculation function.
The disadvantage of the IRR method is that it can yield abnormally high rates of return by overestimating the value of reinvesting cash flow over time.
A Modification of the Internal Rate of Return Method
The modified rate of return method overcomes the tendency to overestimate returns by using the company’s current cost of capital as the rate of return on reinvested cash flow.
As with all methods of capital budgeting, the modified rate of return method is only as good as the variables used to calculate it. However, by using the firm’s cost of capital as one variable, it has a figure that is grounded in a verifiable current reality and is the same for all alternatives being evaluated.
The Accounting Rate of Return
Many financial professionals in a firm, as opposed to top management, prefer the accounting rate of return because it is most grounded in actual numbers. Determining an investment’s accounting rate of return is a matter of dividing the expected average profit after taxes from the investment by the average investment. However, as with the payback period method, it does not account for the time value of money.