Adding full time employees, buying a building, buying new equipment, investing in a new product line, or purchasing another business are all long-term decisions many businesses face. Management needs to make sound decisions regarding these long-term projects based on what will make more sense economically for the business. While there are many ways management can make these decisions, this paper will evaluate the four most common capital budgeting techniques using financial analysis models that calculate the projects payback period, net present value, internal rate of return, and profitability index. Capital Budgeting Techniques
Businesses face long-term decisions such as whether or not to add full time employees, buy a building, buy new equipment, invest in new product line, or purchase another business. In order to make these decisions, management normally relies on techniques that calculate the economical soundness of proposed projects. Capital budgeting is the process of planning and justifying how capital dollars are spent on long-term projects and provides methods through which projects are evaluated to decide if the company should partake in the project (Lasher, 2011, p. 456). The theory behind capital budgeting is based on the time value of money with the central concept that an investment only makes sense if it earns more than the cost of funds put into it (Lasher, 2011, 457). While there are many ways management can make these decisions, most companies use financial analysis models that analyze whether the cash inflows exceed the cash outflows of particular projects. The four most common capital budgeting techniques are the payback period, net present value, internal rate of return, and profitability index.
Of the four capital budgeting techniques, the easiest to use is the payback period. It calculates the amount of time it takes for a projects planned cash flows to “pay back” the initial outlay (Lasher, 2011, p. 458). The idea behind the payback period method is that it is better to recover invested money sooner than later; therefore, projects with a lower payback period are more favorable (Lasher, 2011, p. 459). Unfortunately, the payback period has its shortfalls. First, it does not take into account the time value of money as current money is valued the same as future money (Lasher, 2011, p. 459). Second, once the payback period is complete, the cash flows generated afterwards are ignored which can lead to wrong assumptions (Lasher, 2011, p. 459). The biggest advantage is its ease of use. There is some evidence that suggests that the payback method is more commonly favored by small firms (Boedeker, Hughes, & Paulson Gjerde, 2011). According to Danielson & Scott (2006), small firms often cite the “gut feel” and the payback period as their primary evaluation tool. Danielson & Scott (2006) feel that it is because 50% of the small business owners surveyed did not have a college degree. In addition, many small have limited management resources and a lack of expertise in finance and accounting to evaluate projects using other discounted cash flows (Danielson & Scott, 2006).
The second capital budgeting technique is the net present value (NPV) technique which analyzes the present value of future cash flows (Lasher, 2011, p. 460). “A project’s NPV is the sum of the present values of its cash inflows and outflows at the cost of capital” (Lasher, 2011, p. 460). Any project in which the present value of planned cash inflows exceed the present value of outflows is considered desirable; therefore, when deciding between multiple projects, the one with the higher NPV should theoretically be chosen. According to Brealey and Myers (2003), a firm should invest in all positive NPV projects and reject those with a negative NPV (Danielson & Scott, 2006). They also believe that firms should make investment decisions that maximize shareholder wealth and because NPV is a complete measure of a project’s