Capital budgeting is a process that is usually adopted by companies to evaluate their long-term investment projects (Mukherjee & Al Rahahleh,2013). The long-term projects may include the purchase of a new machinery, replacement of an old machinery, an introduction of a new product line among others. To evaluate these long-term projects, the following capital budgeting techniques are usually employed:
Payback period (PBP) : Payback period is the most basic capital budgeting technique used. The technique determines how long the project will take to pay back the initial investment. It is calculated simply by dividing projects total cost by the number of years. Its decision criteria is that project with the lower PBP should be preferred (Mukherjee & Al Rahahleh,2013). The major weakness of this technique is that it ignores the time value of money as it uses undiscounted cash flows.
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Net Present Value (NPV) : This is the most common and most effective capital budgeting technique as it uses discounted cash flows (Bierman & Smidt, 2014). Net present value of a project is calculated as the difference between projects discounted cash inflows minus discounted cash outflows. Its decision criteria is that the project with the highest NPV should be preferred.
Internal Rate of Return (IRR) : IRR is a discount rate that is obtained when NPV of a project is zero. Its decision criteria is that higher IRR should be preferred.
Profitability Index (PI): It is a ratio of present value of a project cash inflow to the present value of a project cash outflows. Its decision criteria is that all projects whose PI is more than one should be accepted and vice versa (Bierman & Smidt, 2014).
Accounting Rate of Return (AAR): It is a capital budgeting technique calculated by dividing expected project’s total net income by total initial investment.
Modified Internal Rate of Return (MIRR): It is a capital budgeting technique that is used to rank alternative investments projects of equal size (Mukherjee & Al Rahahleh,2013). Basically, MIRR is used to resolve problems posed by IRR. Therefore, MIRR can be used to rank projects in the event where more than one IRR is found for a project with alternating positive and negative cash flows which might cause confusion, thus, making MIRR suitable in such a case as it will give only one value.
In my opinion, therefore, net present value (NPV) is the most useful of all capital budgeting techniques. Its usefulness can be attributed to the fact that the technique takes into account time value of money by using discounted cash flows. Also, it is very useful since where a conflict arises between NPV and any other capital budgeting technique, the NPV decision shall prevail.
References
Bierman Jr, H., & Smidt, S. (2014). Advanced capital budgeting: Refinements in the economic analysis of investment projects . Routledge.
Mukherjee, T. K., & Al Rahahleh, N. M. (2013). Capital budgeting techniques in practice: US survey evidence. Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects , 151-171.
