Capital Budgeting Techniques- Discounting and Non-discounting Methods

Capital Budgeting Technique

Due to rapid changes in business environment, business enterprises face the challenge of choosing between existing projects and new projects given the finite resources. Therefore, business managers in allocating resources are required to evaluate and choose the most viable projects between existing operations and new projects. According to Maroyi & van der Poll (2012), business managers use capital budgeting as an appraisal method to choose capital projects, either existing or new, to allocate resources. Shim & Siegel (2008) describe capital budgeting as investment decision tools used by business managers to evaluate worthiness of pursuing certain long-term capital projects. Emery, Finnerty & Stow (2007) continues to assert that capital budgeting is an appraisal tool used by business managers to make decisions on equipment replacement, expansion and product development. In essence, managers use capital budgeting techniques to determine profitability and viability of expanding business, launching new products, replacing old equipments with new equipments.

Capital budgeting techniques use two methods, namely discounting methods and non-discounting methods. Discounting approaches are hinged on time value of money concept while non-discounting methods are not based on time value of money concept. Net present value and internal rate of return (IRR) are capital budgeting techniques that use time value of money concept. Emery et al., (2007) observe that profit index, accounting rate of return and payback period are capital budgeting techniques that use non-discounting methods. The choice of the method to use depends on management decision and the type of project.

Discounting Methods of Capital Budgeting

Net present value is a capital budgeting technique that uses discounting method and because it takes into consideration the value of money over time, NPV is considered a sophisticated appraisal method. In using the NPV, the capital budgeting technique requires projection of cash flow and their timing. Cash flows are then discounted using appropriate discount rate to obtain discounted value of future cash flow. The discount rate is mostly the weighted average cost of capital of the firm. Risky projects are discounted using a high discount rate while low risk projects are discounted using low discount rates. Emery et al., (2007) assert that the present value of future cash flows is compared with the required cash outlay. If cash outlay is greater than the present value of future cash flow, the project is not worth undertaking, thus abandoned. If present value of future cash flow is greater than the cash outlay, the project should be accepted (Baker et al., 2008). The method has various advantages, such as it considers cash flow, takes into consideration time value of money, considers risk of future cash flow and determines increase of firm’s value because of investing in the project. On the other hand, NPV suffers from numerous set backs, such as it is difficult to estimate future cash flow and it is difficult to estimate the cost of capital.

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The internal rate of return is a capital budgeting techniques that take into consideration the time value of money in assessing the worthiness of undertaking a certain capital project. According to Baker et al., (2008) the internal rate of return is the discount rate that yields a net discounted value of future cash flows of zero. Therefore, the internal rate of return is the rate of return on investment for the firm. If the internal rate of return is greater than the cost of capital, the project should be accepted. However, if the IRR is less than the return the company requires, the project should be abandoned (Baker et al., 2008). Just like the NPV method, internal rate of return has advantages and disadvantages. The advantages of IRR are, IRR takes into factor the internal rate of return, uses all cash flow in assessing viability of a project and IRR is used to determine the value a project adds to the firm. On the other hand, IRR suffers from various setbacks such as IRR is subjective because it yields multiple rates of return, IRR assumes constant cost of capital and cash flows during the service life of a project and the benchmark rate that is the cost of capital is an estimate.

Profitability index is a capital budgeting technique that takes into consideration the value of money over time. Since business firms are faced with numerous project opportunities, business managers use profitability index to select the most profitable project from a number of projects. Profitability index is obtained by dividing the discounted value of future cash flows with the cash outlay. Investment decision is made based on the comparison of profitability index of many projects. For example, business managers will accept a project with the highest profitability index among numerous projects competing for capital (Emery et al., 2007). Advantages of profitability index is, it takes into consideration the time value of money, takes into consideration all cash flows to be generated during the service life of a project and is useful in ranking projects. Profitability index also suffers from numerous setbacks, such as the cost of capital used to calculate net present value of cash flow is an estimate and profitability index is not a good appraisal tool for mutually exclusive projects.

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Non-discounting Methods of Capital Budgeting

Business managers use methods that do not take into consideration the value of money over time in determining viability and the worthiness of a project. The most commonly used non-discounting methods of capital budgeting are payback period and accounting rate of return (Shim & Siegel, 2008). Payback period measures the time it will take a business firm to recover its cash outlay in a capital project. According to Emery et al., (2007), the shorter the period, the desirable is the project. Payback period has a set of advantages that makes it desirable to use in investment appraisal. The advantages include payback period is easy to compute and it is a good measure of liquidity. However, payback period suffers from numerous setbacks that make it unsuitable for investment appraisal. The disadvantages are it does not take into consideration the value of money over time, it does not consider all cash flows because it ignores cash flows after payback period and it ignores the risks of a project.

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Accounting rate of return, just like the payback period method, is a non-discounting method of investment appraisal. However, unlike the other methods, it uses net income or accounting profits instead of cash flows. Accounting rate of return (ARR) yields the return on investment of the company based on annual net income. According to Shim & Siegel (2008), accounting rate of return is simply a ratio of average annual net income to average initial investment. A project with an accounting rate of return higher than the required rate of return for the firm is accepted. Nevertheless, a project that has an accounting rate of return lower than the required rate of return for the firm is abandoned. Accounting rate of return has an advantage that, it is simple to compute. Baker et al., (2008) opine that accounting rate of return should not be used in isolation because it ignores the value of money over time and risk, it uses accounting profits instead of cash flows and it does not measure additional investment value a project brings to a firm.

References

Baker, R. Lembke, V. King, T. & Jeffrey, C. (2008). Advanced financial accounting. (8th Ed.). New York: McGraw-Hill Companies.

Emery, D. R., Finnerty, J. D & Stow, J. D. (2007). Corporate financial management. (3rd ed.). Prentice Hall International.

Maroyi, V. & van der Poll, H. M. (2012). A survey of capital budgeting techniques used by listed mining companies in South Africa. African Journal of Business Management, 6(32), 9279-9292.

Shim, J. K & Siegel, J. G. (2008). Financial management. (3rd ed.). New York: Barron’s Educational Series Inc.

Author Bio

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