The Three Methods of Evaluation Under the Capital Budgeting Process

Beneficial attributes of capital investments should be evaluated in cash to ensure only viable projects are undertaken.

Investments in capital-intensive projects have a long-term effect on the company's value, and they should be evaluated on their viability. The capital budgeting process ensures that a company invests its current funds most efficiently in the long-term assets that offer highest expectations of flow of benefits over a series of years. The investment and benefits should be evaluated based on criteria compatible with shareholders' wealth maximization objective.

Internal Rate of Return

Companies invest in projects that have a return that is higher than their cost of capital. Internal rate of return equates the net present value of a projects cash inflow to the present value of investment costs. The decision criterion is to accept investments that have returns higher than the cost of capital of the company, though management may set a higher rate to be used as acceptance criterion for selecting investments.

Payback Period

When companies are investing in capital assets, they set a duration in which the initial capital outlay should have been recouped. This payback period ensures that the company invests in projects whose payback period is less than the standard set by management. The project with the shortest payback period is selected when there is more than one mutually exclusive project. Payback period has an advantage of being simple and cost-effective to use.

Net Present Value

The net present value method determines the present value of the cash inflows and subtracts the present value of initial capital outlay. The discount rate used is equal to the required rate of return expected by investors on investments of equivalent risks. This method takes into account the fact that a dollar today is worth more than a dollar in future. The decision criterion is to accept a project with a positive net present value. A project with the highest net present value is accepted where there are more than one mutually exclusive investment projects.

Accounting Rate of Return

The annual accounting profits from an investment are compared with the cost of initial outlay in measurement of the project's viability. Decision criteria are to choose the project that is able to cover the costs of investment and give a company required returns. Where there are competing projects that are mutually exclusive, the project with highest accounting rate of return is chosen.

References

• "Basic Finance": An Introduction to Financial Institutions, Investments and Management; Harbert B. Mayo; 9th edition; 2007
• "Fundamentals of financial Management": Eugene F.Brigham; et al; 10th edition; 2004
• "Corporate Finance": Stephen A. Ross; et al; 2nd edition;1990