Capital Budgeting and Sustainability

Capital budgeting involves evaluating the profitability of prospective investments.

Organizations use capital budgeting to evaluate the feasibility of long-term projects, such as major investments earmarked for technological and production improvements. Capital budgeting evaluates the sustainability of prospective investments or projects based on profitability. Assessment techniques include net present value, internal rate of return, discounted payback period and profitability index.

Net Present Value

In capital budgeting, net present value, or NPV, is a technique used to evaluate the potential profitability of a new investment or project. This includes a valuation of the cash outflows to sustain an investment against its future cash inflows. For example, say that an investment's future cash returns have a present value of $100,000, after discounting cash outflows on the investment project. An assessment of whether the investment is profitable will generally depend on whether its current market value, if sold today, would return more than $100,000.

Discounted Payback Period

The discounted payback period is a capital budgeting technique used to calculate the number of years it will take an investment or project to break even. A discounted payback period will not exist for an investment that has a negative NPV because the initial cash outflow will never be recovered. When making a business case for sustainable investments, project managers seek projects with the shortest possible discounted payback period.

Profitability Index

The ratio between a cash outflow on an investment and its prospective payoff is its profitability index, also referred to as profit investment ratio, benefit-cost ratio and value investment ratio. This is a capital budgeting technique that is used to grade an investment by assessing its benefit-cost ratio. Twelve percent of companies used the profitability index capital budgeting technique, among the least frequently used of capital budgeting methods, according to a 2002 survey conducted by John Graham and Campbell Harvey of Duke University.

Internal Rate of Return

The internal rate of return, or IRR, is a capital budgeting method used to evaluate the potential growth of a project. Like the NPV capital budgeting technique, the IRR methodology is a time-adjusted measurement of the profitability of an investment. IRR is a good tool for comparing the profitability and sustainability of different investment opportunities.

References

• "Journal of Applied Corportate Finance"; How Do CFOs Make Capital Budgeting and Capital Structure Decisions?; John Graham, et al.; Spring 2002
• Congressional Budget Office: Capital Budgeting