Techniques Most Preferred for Capital Budgeting

by Dana Griffin
Companies employ capital budgeting techniques to make sound decisions when considering long-term investments.

Companies employ capital budgeting techniques to make sound decisions when considering long-term investments.

Capital budgeting techniques help companies create strategies for current and future projects. A business has limited resources and therefore must analyze its operations, expenses and assets before making positive, informed decisions. Today's companies employ a handful of budgeting techniques to devise these strategies.

Guidelines for Capital Budgeting

Capital budgeting projects are long-term investments. Companies expect these projects to produce cash flows over a certain length of time, normally a few years. According to Mark Lane, "The decision to accept or reject a capital budgeting project depends on an analysis of the cash flows generated by the project and its cost." Good capital budgeting methods examine the project's cash flows and take into account the time value of money -- or the worth of money invested over time compared to its current worth in hand. It helps decide which to choose when correctly comparing mutually exclusive projects.

Internal Rate of Return

William Cooper of "Entrepreneur" notes that the rate of return "is the ratio of the project's average after-tax income to its average book value." By comparing the cost of a project to its current value, a company calculates the internal rate of return. The internal rate of return is the rate at which the investor forecasts to profit on a risk. This return must be determined through trial and error; there is no hard and fast formula. When a project's internal rate of return surpasses its minimum rate of return, it is a sensible venture.

Net Present Value

The net present value method of capital budgeting determines the worth of a project by calculating the overall increase of company value. This model aims to account for the devaluation of money over time. Subtracting the potential income a project produces from the company's current rate of return reveals the net present value of a project. When examining the net present value of an endeavor, companies should look to see if the profits are enough to pay back the cost of assets and the project investment while meeting a satisfactory rate of return to counterbalance the company's risk.

Payback Model

The payback model calculates the time requisite for the company to recoup its first investment after taxes. For example, to recoup $60,000 at the rate of $5,000 per year would require 12 years. The payback model helps companies choose projects based on the profitability index. "Entrepreneur" defines the profitability index as "the ratio of the project's value to its initial investment." Following this method, the company should chose projects displaying positive outcomes on the profitability index and reject projects that won't reach payback within the specified time. One drawback of this model is its failure to account for the potential of additional profits after redeeming the initial investment.

About the Author

Dana Griffin has written for a number of guides, trade and travel periodicals since 1999. She has also been published in "The Branson Insider" newspaper. Griffin is a CPR/first-aid instructor trainer for the American Red Cross, owns a business and continues to write for publications. She received a Bachelor of Arts in English composition from Vanguard University.

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