Capital Budgeting Techniques
A comprehensive guide to evaluating long-term investment projects
1. Overview of Capital Budgeting Techniques
Definition: Capital budgeting is the process by which firms evaluate and
select long-term investment projects.
Key Techniques:
Payback Period
Discounted Payback Period
Average Accounting Return (AAR)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Profitability Index (PI)
2. Payback Period
Definition: The time required for a project's cash inflows to recover the
initial investment.
Decision Rule: Accept if payback period ≤ a predetermined cutoff period.
Example:
Initial Investment: $10,000
Cash Inflows:
Year 1: $3,000
Year 2: $4,000
Year 3: $5,000
Step-wise Calculation:
Cumulative Cash Flow:
o Year 1: $3,000
o Year 2: $3,000 + $4,000 = $7,000
o Year 3: $7,000 + $5,000 = $12,000
Payback occurs between Year 2 and Year 3.
Exact Payback = 2 + ($10,000 - $7,000)/$5,000 = 2.6 years
Limitations:
Ignores time value of money and cash flows beyond payback period.
3. Discounted Payback Period
Definition: Similar to payback period, but uses discounted cash flows
(present values).
Example:
Initial Investment: $10,000
Discount Rate: 10%
Cash Inflows:
Year 1: $3,000 → PV = $3,000 / 1.10 = $2,727.27
Year 2: $4,000 → PV = $4,000 / 1.10² = $3,305.79
Year 3: $5,000 → PV = $5,000 / 1.10³ = $3,756.57
Step-wise Calculation:
Cumulative Discounted Cash Flow:
o Year 1: $2,727.27
o Year 2: $2,727.27 + $3,305.79 = $6,033.06
o Year 3: $6,033.06 + $3,756.57 = $9,789.63
Payback not achieved by Year 3 since cumulative PV < $10,000.
Limitations:
Still ignores cash flows beyond payback period.
4. Average Accounting Return (AAR)
Definition: AAR = Average Net Income / Average Book Value of Investment
AAR = (Average Net Income) / (Average Book Value of Investment)
Example:
Initial Investment: $10,000
Useful Life: 3 years
Salvage Value: $1,000
Net Income:
Year 1: $2,000
Year 2: $3,000
Year 3: $4,000
Step-wise Calculation:
Average Net Income = ($2,000 + $3,000 + $4,000)/3 = $3,000
Average Book Value = (Initial Value + Salvage Value)/2 = ($10,000
+ $1,000)/2 = $5,500
AAR = $3,000 / $5,500 = 54.55%
Limitations:
Uses accounting income, not cash flows; ignores time value of money.
5. Net Present Value (NPV)
Definition: NPV = Present Value of Cash Inflows - Initial Investment
Decision Rule: Accept if NPV > 0
NPV = ∑ [Ct / (1+r)t] - C0
Example:
Initial Investment (C₀): $10,000
Cash Inflows:
Year 1: $3,000
Year 2: $4,000
Year 3: $5,000
Discount Rate (r): 10%
Step-wise Calculation:
PV of Year 1 = $3,000 / 1.10 = $2,727.27
PV of Year 2 = $4,000 / 1.10² = $3,305.79
PV of Year 3 = $5,000 / 1.10³ = $3,756.57
Total PV = $2,727.27 + $3,305.79 + $3,756.57 = $9,789.63
NPV = $9,789.63 - $10,000 = -$210.37
Decision: Reject (NPV < 0)
6. Internal Rate of Return (IRR)
Definition: IRR is the discount rate that makes NPV = 0.
Decision Rule: Accept if IRR > cost of capital
0 = ∑ [Ct / (1+IRR)t] - C0
Example:
Initial Investment: $10,000
Cash Inflows:
Year 1: $3,000
Year 2: $4,000
Year 3: $5,000
Step-wise Calculation (Trial and Error):
Try r = 10%: NPV = -$210.37
Try r = 8%:
o PV Year 1 = $3,000 / 1.08 = $2,777.78
o PV Year 2 = $4,000 / 1.08² = $3,429.36
o PV Year 3 = $5,000 / 1.08³ = $3,969.16
o Total PV = $10,176.30
o NPV = $176.30
IRR is between 8% and 10%.
Using interpolation:
o IRR ≈ 8% + (176.30 / (176.30 + 210.37)) × (10% - 8%) ≈
8.91%
Choosing Between Two IRRs: For non-conventional cash flows, use the
one closest to the firm's cost of capital.
7. Modified Internal Rate of Return (MIRR)
Definition: MIRR assumes reinvestment at the firm's cost of capital.
MIRR = (FVpositive cash flows / PVnegative cash flows)1/n - 1
Example:
Same cash flows as above, cost of capital = 10%
Step-wise Calculation:
Reinvest cash inflows at 10%:
o Year 1: $3,000 × (1.10)² = $3,630
o Year 2: $4,000 × (1.10)¹ = $4,400
o Year 3: $5,000 × (1.10)⁰ = $5,000
Total FV = $13,030
MIRR = ($13,030 / $10,000)1/3 - 1 ≈ 9.23%
8. Comparing NPV and IRR
NPV IRR
Absolute measure of value Relative measure of return
Consistent with value May conflict with NPV for mutually
maximization exclusive projects
Uses cost of capital as
Calculates break-even discount rate
discount rate
Conflict Example:
Two projects: Project A (NPV=$500, IRR=15%) and Project B (NPV=$600,
IRR=12%). If mutually exclusive, choose Project B (higher NPV).
9. Profitability Index (PI)
Definition: PI = Present Value of Future Cash Flows / Initial Investment
Decision Rule: Accept if PI > 1
PI = (Present Value of Future Cash Flows) / (Initial Investment)
Example:
From NPV example:
Total PV = $9,789.63
Initial Investment = $10,000
PI = $9,789.63 / $10,000 = 0.979
Decision: Reject (PI < 1)
Summary
Payback and Discounted Payback are simple but ignore cash flows
beyond payback.
AAR uses accounting data, not cash flows.
NPV is the most reliable and consistent with value maximization.
IRR is popular but may conflict with NPV for mutually exclusive
projects.
MIRR addresses reinvestment assumption and multiple IRR issues.
PI is useful for ranking projects when capital is limited.
Summary Table
Metho Decisio Advantage Disadvantag
Definition
d n Rule s es
Time to
Simple, Ignores TVM,
Paybac recover Payback
liquidity cash flows
k initial < Cutoff
bias after payback
investment
Considers
PV of
TVM, all Requires
inflows
NPV NPV > 0 cash flows, discount rate
minus PV
maximizes estimation
of outflows
value
Discount
IRR > Considers Multiple IRRs,
rate that
IRR Cost of TVM, reinvestment
makes NPV
Capital intuitive assumption
=0
Metho Decisio Advantage Disadvantag
Definition
d n Rule s es
PV of
future cash
Useful for
flows Scale
PI PI > 1 capital
divided by problems
rationing
initial
investment
Key Takeaway:
NPV is the theoretically soundest method and should be the primary decision
criterion, with other methods providing supplementary information.