Capital budgeting – also called project appraisal – is a planning process which is used to determine whether a long time investment is worth pursuing. Many mathematical techniques are used in capital budgeting. These techniques are: payback period, discounted payback period, accounting rate of return, net present value, profitability index, internal rate of return and modified internal rate of return.
Capital budgeting plays a key role in the decision making in an organization. A decision on where to invest the company’s finances must be taken after careful consideration of the investment’s ability to give future returns. Any profit-based project must be able to give returns in the future. Otherwise, an investor should not consider investing in that project.
The payback period is used to find out how long it will take for the invested amount to be paid back to the investor. It does not consider the present value of cash flows. Discounted payback period is similar to payback period, but it considers the present value of cash flows. The average return rate is given by dividing the average profit by the average investment. If an investment does not achieve the required rate of return it is rejected. Otherwise, it is accepted. The average rate of return does not consider the time value of money. Profitability index, a ratio that is calculated by the division of future cash flows’ the present value by initial investment is another measure of capital budgeting (Joseph, 2008). A project is accepted only when the ratio is greater than 1. Net present value is given by finding the difference between the present value of all expenses and the present value of all incomes. A project is accepted only when the net present value is positive. The internal rate of return is the discount rate at which the net present value of all benefits equals the net present value of all costs. The project with a high internal rate of return is considered over an investment with a low internal rate of return. For a single investment, the internal rate of the project’s return should be higher than the company’s internal rate of return. Modified internal rate of return is a modification that is brought about by internal rate of return. The internal rate of return can have more than one value and cannot be used where the cash flow sign changes during the project’s life. The modified internal rate of return tries to solve these problems.
The disadvantage of payback period and discounted payback period is that they both have no concrete decision criteria to determine whether the investment increases a firm’s value. The net present value, profitability index, internal rate of return and modified internal rate of return have the common disadvantage of requiring an estimated capital cost in order to calculate them. However, net present value and profitability index are preferred when comparing mutually independent projects or when there is capital rationing.
Ms Annabelle’s stores’, a neighborhood grocery store that features a wide range of goods from fresh foods to hardware and building items, potential investment areas may include opening a new branch, rebranding or aggressive marketing to increase sales.
For Annabelle’s grocery store, the best process to use in capital budgeting is the net present value especially when comparing two mutually exclusive projects. This is because the net present value considers all cash flows, time value of money, risk of future cash flow and helps determine whether an investment will increase a firm’s future value (Sullivan, 2003).
Huge sums of money could be easily wasted if an uneconomic investment is conducted. The importance of capital budgeting as a key aspect in any successful organization cannot be undermined. Capital budgeting can only work if a corporation sets clear long term goals, standards which potential projects have to meet before they can be undertaken and accurate determination of the future return’s rate and cash flows. This will enable an organization to determine the most appropriate technique of project appraisal that best suits its needs.