The key to effective decision making is evaluating alternatives and selecting the most feasible and valuable among the options. Capital budgeting is a quantitative assessment that involves forecasting future performance to make long-term investment decisions. Capital budgeting techniques may use data from financial and operating reports to predict potential performance of corporate investment and strategic options.
The capital budgeting process is generally more formal than evaluations for short-term investments. In most businesses, this generally involves a five-step process. The steps include gathering investment ideas, performing a cost-benefit analysis on the proposed investments, ranking the appeal of each proposed investment, implementing the selected investment and evaluating the implemented investment.
A number of capital budgeting valuation methods exist. The payback period method is a simple capital budgeting technique that involves calculating the number of years it will take to recover the initial cash invested. The investment alternative with the quickest payback is preferred. For example, if choosing among capital outlays for two new technology investments, the technology that offers the fastest return on the initial investment would be selected. The technology not chosen may -- over the long-run -- provide a greater return, but not within the term of the payback period set by management. In some situations, a short-term payback period assessment might be required due to the requirement to pay associated debt obligations.
Internal Rate of Return
The internal rate of return is another type of capital budgeting technique. It measures the yield on investments by discounting the present value of all cash inflows against the sum of all cash outflows for an investment to determine the earnings over the life of a project. In comparing and ranking alternatives, the project with the highest earning potential is deemed the most desirable. Keep in mind that the IRR method might reveal no rate of return from a potential investment. It might also reveal misleading comparisons, say, if the timing of the cash flows is different for each investment option.
Discounted Cash Flow
The discounted cash flow method takes into account the time value of money by discounting an investment's future return to a present value. The premise of the time value of money is that a dollar in-hand today is worth more than the same dollar in the future. In more sophisticated capital budgeting valuations, this discount is taken into consideration when the present value of the future return is assessed against the present value of the cash outflows on an investment.
- "Corporate Financial Analysis in a Global Environment"; Diana R. Harrington; 2001
- Ohio State University Fisher College of Business; A New Perspective on Multiple Internal Rates of Return; Gordon B. Hazen; June 2002
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