I.

Introduction

A. Definition of Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investments
that are consistent with the firm’s goal of maximizing owner wealth. Capital budgeting
is a critical process for business aiming to make prudent investment decisions regarding
long-term asset and projects. This report provides an insightful analysis of various
capital budgeting techniques employed by organizations to effectively allocate resources.

B. Importance of Capital Budgeting Techniques for Businesses

Capital budgeting techniques plays a pivotal role in the strategic decision-making
process of businesses, serving as a compass for prudent investment choices. These
methodologies enable firms to assess potential long-term investments and determine
their financial viability, aiding in the allocation of scarce resources towards projects with
the highest potential for profitability and growth. Moreover, these techniques facilitate
the alignment of investment decisions with the overarching organizational objectives,
fostering a coherent and integrated approach to resource allocation. Through the
application of capital budgeting tools such as Net Present Value (NPV), Internal Rate of
Return (IRR), Payback Period, and Profitability Index, businesses can not only optimize
their capital allocation but also enhance their competitiveness, sustainability, and long-
term financial performance in an ever-evolving and dynamic business environment.

C. Purpose and Scope

The purpose of the report is to provide a comprehensive understanding of various
capital budgeting techniques and their significance in aiding businesses to make
informed investments decisions. It seeks to offer practical insights into the application
of key techniques to assess the feasibility, risks, and potential returns associated with
long-term investment projects.

The scope of the report encompasses an in-depth exploration of the fundamental

concepts and calculations involved in each capital budgeting technique, providing a
clear understanding of their respective strengths and limitations.

II. Fundamentals of Capital Budgeting

A. Overview of Long-Term Investment Decision Making

Long term investment decision-making entails a strategic process in which

businesses assess and select investment opportunities that are expected to yield returns
over an extended period. This involves a comprehensive evaluation of potential projects
or assets, considering factors such as risk, return, market trends, and the organization’s
long-term objectives. Businesses must conduct thorough analyses of cash flows, market
conditions, and potential risks associated with the investment to ensure the feasibility
and profitability of the chosen ventures. Additionally, considerations of capital
budgeting techniques and financial modeling are crucial in making informed decisions
about resource allocation.
B. Role of Capital Budgeting in Financial Management

The role of capital budgeting in financial management is crucial as it facilitates

the effective allocation of financial resources to maximize long-term profitability and
sustainability. It assists in the evaluation and selection of investment projects that align
with the organization’s strategic goals and financial objectives. By employing various
capital budgeting techniques, businesses can assess the potential risks and returns
associated with different investment opportunities, enabling them to make well-
informed decisions about resource allocation. Additionally, capital budgeting aids in
optimizing the utilization of funds by prioritizing projects with the highest potential for
generating positive cash flows and enhancing shareholder value.

III. Capital Budgeting Techniques

A. Payback Period

Payback periods are commonly used to evaluate proposed investments. The

payback period is the amount of time required for the firm to recover its initial
investment in a project, as calculated from cash inflows. In the case of annuity, the
payback period can be found by dividing the initial investments by the annual cash
inflow. Businesses use this method to assess the risk associated with an investment by
determining how quickly they can recover their initial investment. The shorter the
payback period, the more attractive the investment. However, the payback period is
generally viewed as an unsophisticated capital budgeting technique, because it does not
explicitly consider the time value of money.

The Decision Criteria:

When the payback period is used to make accept-reject decisions, the decision criteria
are as follows:

➢ If the payback period is less than the maximum acceptable payback period,
accept the project.
➢ If the payback period is greater than the maximum acceptable payback
period, reject the project.
Example:
We can calculate the payback period for Bennett Company’s projects A and B using the
data in Table 9.1. For project A, the payback period is 3.0 years ($42,000 initial
investment ÷ $14, 000 cash inflow). Because project B generates a mixed stream of cash
inflows, the payback period is not as clear-cut. By the end of year 2, $ 40,00 cash inflow
will have been recovered. At the end of year 3, $50, 000 will have been recovered. Only
50% of the year 3 cash inflow is needed to complete the payback of the initial $45, 000
dollars. The payback period for project B is 2.5 years. So, if Bennett’s maximum
acceptable payback period were 2.75 years, project A would be rejected and project B
would be accepted.
Pros and Cons of Payback Period

The pay back period is widely used by large firms to evaluate small projects and by small
firms to evaluate most projects. This technique has several advantages. Firstly, it
provides a straightforward and easy-to-understand measure of investment risk, helping
businesses assess the liquidity and cash flow characteristics of a project. It also
promotes a focus on short-term profitability, which can be particularly useful for
businesses with limited liquidity or those operating in rapidly changing industries where
quick returns are essential. Additionally, it aids in setting investment time horizons,
thereby assisting in aligning investment decisions with the company’s overall financial
strategy.

However, the payback period method also has notable limitations. The major weakness
of the payback period is that the appropriate payback period is merely a subjectively
determined number. It cannot be specified in light of the wealth maximization goal
because it is not based on discounting cash flows to determine whether they add to the
firm’s value. A second weakness is that this approach fails to take fully into account the
time factor in the value of money.
Example:

Da Yarman Enterprises is considering two mutually exclusive projects, named projects

Gold and Silver. The relevant cash flows and pay back period for each project are given
in table 9.2. Both projects have 3- year payback periods, which would suggest that they
are equally desirable. But comparison of the pattern of cash inflows over the first 3 years
shows that more of the $50,000 initial investment in project Silver is recovered sooner
than is recovered for project Gold. Given the time value of money, project Silver would
clearly be preferred over project Gold, in spite of the fact that they both have identical
3-year payback period. The payback period does not fully account the time value of
money, which if recognized, would cause project Silver to be preferred over project Gold.

A third weakness of payback period is its failure to recognize cash flows that occur
after the payback period.
Example:
The payback period for project X is 2 years; for project Y is 3 years. Payback approach
suggests that project X is preferable to project Y. However, if we look beyond the
payback period, we see that project X returns only an additional $1,200, whereas
project Y returns an additional $7,000. On the basis of this information, project Y
appears preferable to X.

B. Net Present Value

Net Present Value (NVP) considers the time value of money. It is considered a
sophisticated capital budgeting technique. All such techniques in one way or another
discount the firm’s cash flows at a specified rate. This rate—often called the discount
rate, required return, cost of capital, or opportunity cost—is the minimum return that
must be earned on a project leave the firm’s market value unchanged. It considers the
time value of money by discounting future cash flows back to their present value using
a specified discount rate. A positive NVP indicates that the investment is expected to
generate returns higher than the discount rate and is, therefore, profitable. On the other
hand, a negative NVP suggests that the investment may not meet the desired rate of
return and may not be financially viable.
The Net Present Value (NVP) is found by subtracting a project’s initial investment
(CFo) from the present value of its cash inflows (Cft) discounted at a rate equal to the
firm’s cost capital (k).

When NVP is used, both inflows and outflows are measured in terms of present
dollars. Because we are dealing only with investments that have conventional cash
flow patterns, the initial investment is automatically stated in terms of today’s dollars.
If it were not, the present value of a project would be found by subtracting the present
value of outflows from the present value of inflows.
The Decision Criteria:

➢ If the NVP is greater than $0, accept the project.

➢ If the NVP is less than $0, reject the project.
We can illustrate the net present value (NVP) approach by using Bernett Company
data presented in Table 9.1.
The calculations in Table 9.2 result in net present values for projects A and B of $11,
071 and $10, 924 respectively. Both projects are acceptable, because the net present
value of each is greater than $0. If the projects were being ranked, project A would be
considered superior to B, because it has a higher net present value than that of B.

Calculator Use- The preprogrammed NVP function in a financial calculator can be

used to simplify the NVP calculation. The key strokes for project A—the annuity---are
shown at left.

The key strokes for project B are shown below.

Because the last three cash inflows for project B are the same
(CF3=CF4=CF5=10,000), after inputting the first of these cash inflows, CF3, were
merely input its frequency, N=3.

Spreadsheet Use- The NVPs can be calculated as shown on the following Excel
spreadsheet.

C. Internal Rate Return (IRR)

The internal rate of return (IRR) is the most widely used sophisticated capital
budgeting technique. However, it is considerably more difficult than NVP to calculate
by hand. The internal rate of return (IRR) is the discount rate that equates the NPV of
an investment opportunity with $0 (because the present value of cash inflows equals
the initial investment. It is the compound annual rate of return that the firm will earn
if it invests in the projects and receives the given cash inflows.

The Decision Criteria

➢ If the IRR is greater than the cost of capital, accept the project.
➢ If the IRR is less than the cost of capital, reject the project.

Calculating the IRR

The actual calculation by hand of the IRR is no easy chore. It involves complex trial
and error technique. Fortunately, many financial calculators have a preprogrammed
IRR function that can be used to simplify the IRR calculation. Computer software,
including spreadsheet, is also available for simplifying these calculations.

Figure 9.3 uses time lines to depict the framework for finding the IRRs for Benett’s
projects A and B., both of which have conventional cash flow patterns. It can be seen in
the figure that the IRR is the unknown discount rate that causes the NPV just to equal
$0.
Calculator Use- To find the IRR using preprogrammed function in a financial calculator,
the key strokes for each project are the same as shown for the NPV calculation, except
that the last two NVP keystrokes are replaced by a single IRR keystroke.

Spreadsheet Use- The internal rate of return also can be calculated as shown on the
Excel spreadsheet below.
It is interesting to note that the IRR suggests that project B, which has an IRR of 21.7
%, is preferable to project A, which has an IRR of 19.9 %.
Comparing NPV and IRR Techniques

Net Present Value (NPV) and Internal Rate Return (IRR) are both crucial capital
budgeting techniques used to evaluate the viability of investment projects. NPV
calculates the present value of expected cash flows by discounting them at a specified
rate, whereas IRR determines the discount rate that equates present value of cash
inflows with the initial investment. While NPV provides the net monetary value of an
investment, IRR offers the percentage return generated by the investment. NPV is
preferred when comparing mutually exclusive projects, considering varying cash flow
patterns, while IRR is more suitable for assessing the profitability of potential
investments and identifying the optimal rate of return.

III. Common Challenges and Criticisms of Capital Budgeting Techniques

1. Uncertainty and Risk Assessment: Difficulty in accurately forecasting future cash
flows and risk factors, leading to potential inaccuracies in the evaluation process.
2. Exclusion of Intangible Factors: Inability to incorporate qualitative aspects such
as social and environmental impacts.
3. Complexity in Evaluation: Challenges in analyzing complex projects with non-
conventional cash flow patterns, leading to potential limitations in accurately
assessing the project’s financial implications.
4. Static Discount Rates: Reliance on fixed discount rates may oversimplify the
evaluation process, overlooking the dynamic nature of investments and
potentially leading to biased decision- making.
5. Limited Managerial Understanding: Difficulties in comprehension and application
of advanced techniques by non-financial managers, hindering their effective
involvement in the decision-making process.

IV. How to Address the Challenges and Criticisms of Capital Budgeting Techniques
1. Sensitivity Analysis: Conduct sensitivity analyses to assess the impact of
changing variables on the investment outcome, providing insights into the
potential risks and uncertainties associated with the project.
2. Incorporating Qualitative Factors: Integrate qualitative considerations such as
environmental impact, social implications, and managerial flexibility into the
evaluation process.
3. Scenario Planning: Utilize scenario planning to anticipate and prepare for various
future possibilities, enabling a more robust evaluation of the project’s resilience
under different economic, market and regulatory conditions.
4. Dynamic Discounting: Implement dynamic discounting techniques that account
for varying risk profiles and cash flow patterns.
 5. Continuous Education and Training: Provide continual education and training
for managers and decision makers to enhance their understanding of capital
budgeting techniques.

V. Conclusion:
Financial managers must apply appropriate decision techniques to assess whether
the project creates value for stakeholders. Net present value (NPV) and internal rate
return (IRR) are the generally preferred capital budgeting techniques. Both use the cost
capital as the required return needed to compensate share-holders for undertaking
projects with the same risk as that of the firm. The appeal of NPV and IRR stems from
the fact that both indicate whether a proposed investment creates or destroys
shareholder value.

In conclusion, capital budgeting techniques serve as essential tools for business to

make informed investment decisions, considering the long-term profitability and
sustainability of projects. While these techniques provide valuable insights into the
financial viability of investments, they are not without limitations. Challenges can
impact the accuracy and relevance of evaluations.
To address these challenges, it is imperative to adopt holistic approach to enhance the
effectiveness of capital budgeting processes. By acknowledging these limitations and
implementing appropriate strategies, businesses can better navigate the complexities of
investment evaluations and optimize their capital allocation for sustainable growth and
success.