Capital Budgeting Evaluation Methods and Techniques (2024)

The techniques and methods for evaluating capital budgeting proposals are:

  • Degree of urgency method
  • Payback period method
  • Unadjusted rate of return method
  • Present value method

The present value method is further divided into the following:

  • Time-adjusted rate of return method
  • Net present value method

An overview of each of these methods, along with examples, is given in this article.

1. Urgency Method

The urgency method does not suggest any specific evaluation method or technique; instead, it provides suggestions about ad hoc decisions.

There are some projects or tasks that require immediate decisions, whereas others are postponed until a future date.

An example of an urgent situation that requires an immediate decision is the breakdown of a machine due to the loss of a key component.

If the component is not replaced, production will suffer, and so it will be prioritized over other projects pending with management for approval.

The urgency method is simple to understand and use. In essence, this is because no method is used at all; only the decision of management is final with regard to urgency.

2. Payback Period Method

This method is also known as the pay-off method or replacement period method. It is a method where a number of years are required to cover the original investment.

This method is based on the theory that capital expenditure pays itself back over a number of years. It highlights the time when the original investment is equal to the earnings generated by that investment.

Thus, the payback period is the time taken to reach the point when the value of the original investment or outflow of cash is equal to the inflow of cash.

The formula to calculate the payback period of an investment is the following:

Payback period = Original investment / Annual cash inflow

The payback period can be:

  • (A) When even cash inflow: This means an equal amount of income every year.
  • (B) When uneven cash inflow: This means when cash inflow is not uniform.

(A) Uniform Cash Inflow

Example

A project costing $200,000 has an annual income of $40,000 and a working life amounting to 8 years. Calculate the payback period.

Solution

Payback period = Original investment / Annual cash inflow

= $200,000 / $40,000 = 5 years

Example

A project costing $1,000,000 has an annual income of $160,000 after depreciation @ 20% p.a. but before tax (which is 50%). Calculate the payback period.

Solution

$
Profit before tax160,000
Less: 50% tax80,000
Profit after tax80,000
Add: Depreciation @ 20% (10,00,000)200,000
280,000

Annual cash inflow payback period = Cash investment / Annual cash inflows

= 10,00,000 / 2,80,000 = 3.57 years

(B) Non-uniform Cash Inflow

YearAnnual Cash Inflow
120,000
225,000
325,000
430,000

Solution

YearAnnual Cash Inflow ($)Cumulative Cash Inflow ($)
120,00020,000
225,00045,000
325,00070,000
430,000100,000

Payback period = 4 years

Evaluation

The shorter the payback period, the greater the viability of the investment. Noteworthily, the payback period method is popular in both the United States and the United Kingdom when evaluating capital proposals.

Advantages of Payback Period Method

The main advantages of the payback period method are the following:

(i) Easy calculations. The main merit of this method is that it is simple to understand and use.

(ii) Knowledge of payback period. Knowing the payback period is valuable for decision-making. Generally, the shorter the payback period, the better the project.

(iii) Protection from loss due to obsolescence. This method is suitable in industries where mechanical and technical changes are routine. If investments with a short payback period are prioritized, losses due to obsolescence can be avoided.

(iv) Useful for reliable conclusions. This method is suited for cash-short companies that have taken a loan for capital expenditure. Shorter periods will result in the short-term return of borrowed capital, meaning that the method offers useful conclusions.

Disadvantages of Payback Period Method

The main disadvantages of the payback period method are as follows:

(i) No thought to period after payback period. The method only focuses on the payback period and, as such, gives little thought to the status of an investment after the period.

(ii) No thought to pattern of income. The pattern of income is not considered. If two projects have the same payback period, the project with a large cash inflow in the initial year is preferred over the project that generates large cash inflows in later years.

(iii) Cost of capital. Under this method, the cost of acquiring capital is not taken into account. Of course, this is a critical point in capital expenditure planning.

(iv) Delicate and rigid method. The method is delicate in its approach. A change in operational cost will affect cash flows and, as such, the payback period will also change.

(v) No thought to project profitability. In this method, no thought is given to the profitability of a project over its life cycle. This technique is not suitable for long-term projects.

3. Unadjusted Rate of Return Method

This is popularly known as the accounting rate of return (ARR) method because accounting statements are used to measure project profitability. Various proposals are ranked in order of their earnings, and the project with a higher rate of return is selected.

ARR can be calculated by dividing the average income over the life of the project by the average investment. In other words:

ARR = Average income / Average investment

There are two approaches to the unadjusted rate of return method:

  • (A) Original investment method
  • (B) Average investment method

(A) Original Investment Method

In this method, average annual earnings or profits over the life of the project are divided by the outlay of capital cost. Thus, ARR is the ratio between average annual profit and the original investment. This can be expressed as follows:

ARR = Average annual profit during project lifetime / Original investment

Example

A project costs $600,000, its scrap is $40,000 after five years, and profits after depreciation and taxes over five years are $50,000, $70,000, $60,000 and $30,000. Calculate the average rate of return on investment.

Solution

Total profits = 50,000 + 70,000 + 80,000 + 60,000 + 30,000 = $2,90,000

= 290,000 / 5 = $58,000

Net investment ($600,000 - 40,000) = $560,000

Average rate of return = (Average annual profit / Net investment) x 100

= (58,000 / 56,000) x 100

= 10.35%

(B) Average Investment Method

In this method, the average profits after depreciation and taxes are divided by the average amount of investment. This can be written as follows:

Average return on average investment = (Average annual profit after depreciation and taxes / Average investment) x 100

Example

Average profit = $50,000

Net investment = $5,00,000

= 50,000 / 2,50,000 = 20%

Average investment = 5,00,000 / 20 = $2,50,000

Advantages of Rate of Return Method

1. Simple method. This method is simple to use and easy to explain.

2. Uses entire earnings. Similar to the payback period method, it does not consider earnings up to the payback period but earnings for all years are taken into account.

3. Based on profit. Accounting projects are easily available from financial data.

Demerits of Rate of Return Method

1. Based on accounting profit. The method lays emphasis on accounting profit and no thought is given to cash inflows by the use of capital projects.

2. No thought to time value of money. In this method, the time value of money is not considered. Of course, this is a useful concept for capital expenditure. As such, variation in projects is not taken into account.

3. Rate of return. In this method, the rates of two or more proposals are compared and not the period of the project, which is a vital factor for decision-making.

4. No thought to re-investment of profits. This method does not give any thought to re-investment, which always affects the rate of return.

5. No thought to sale of existing plant. This method does not consider the sale value of the existing investment. No thought is given to incremental cash outflows, which should be considered to arrive at a correct financial decision.

4. Time-adjusted or Discounted Cash Flow Methods

The methods discussed so far lack the study of equal weight to present and future flow of incomes.

Furthermore, these methods neglect to consider the time value of money (i.e., that a dollar earned today has more value than a dollar earned after five years).

By contrast, time-adjusted or discounted cash flow methods take into account both profitability and the time value of money. The available methods in this category are the following:

  • (A) Net present value method
  • (B) Internal rate of return method
  • (C) Profitability index method

(A) Net Present Value Method

This is a modern method of evaluating capital budgeting proposals. In this method, the time value of money is calculated on different investment proposals.

The value of one dollar earned today is more than the same dollar earned tomorrow.

The net present value of all inflows and outflows of cash occurring during the entire life of the project is determined separately for each year by discounting these flows by the firm's cost of capital.

The steps used to evaluate capital budgeting proposals using the net present value method are the following:

(i) Cut-off rate. This is the rate of return below which investment is deemed not worthwhile.

(ii) Calculation of net present value. Cash outflows are calculated at the determined rate of discount.

(iii) Calculate present value of total investment: This involves proceeds in cash outflows at the specified discount rate.

(iv) Calculate net present value of each project: This involves subtracting the present value of cash inflows from the present value of cash outflows for each project.

(v) Rejection: When inflows are less than outflows, reject the proposals.

Advantages of Net Present Value Method

(i) Entire economic life. Under this method, the entire economic life of the project is taken into account.

(ii) Due weight to time factor. This method is most suitable for long-term capital expenditure decisions.

(iii) Due coverage to risk and uncertainty. Under this method, risk and uncertainty are adequately analyzed. It is a measure of the profitability of capital expenditure that involves reducing the earnings to the present value of each investment.

(iv) Suitable method for evaluation. This method is most suitable when cash inflows are non-uniform. Here, cash inflows and cash outflows are associated with decision-making, whereas in other methods, average revenues are taken into consideration.

Disadvantages of Net Present Value Method

(i) General complexity. The discounted cash flow method is replete with complex calculations that many analysts find difficult to perform.

(ii) Economic life. Determining the economic life of the machine is not simple.

(iii) Complex rate determination. Determining the discount rate is also not simple.

Example

Calculate the net present value for Proposals A and B when the discount rate is 10%. The cash flows shown below are before depreciation and after takes.

YearAB
$$
15,00020,000
210,00010,000
310,0005,000
43,0003,000
52,00020,000
AB
Investment ($)20,00030,000
Life of Investment (years)55
Scrap Value ($)1,0002,000

Solution

YearCash Inflow10% DiscountNet Present ValueCash FlowNet Present Value
15,000.9094,54520,00018,180
210,000.8268,26010,0008,260
310,000.7517,5105,0003,755
43,000.6832,0493,0002,049
52,000.6211,2422,0001,242
Scrap Value1,000.6216212,0001,242
24,22734,728
Less: Capital Investment20,00030,000
Net Present Value4,2274,728

Capital Budgeting Evaluation Methods and Techniques (2024)

FAQs

What are the methods of evaluation of capital budgeting? ›

There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment. They include the Payback Period, Discounted Payment Period, Net Present Value, Profitability Index, Internal Rate of Return, and Modified Internal Rate of Return.

Which of the following capital budgeting evaluation techniques? ›

An assessment of the different funding sources for capital expenditures is needed. Payback Period, Net Present Value Method, Internal Rate of Return, and Profitability Index are the methods to carry out capital budgeting.

What are the 7 capital budgeting techniques? ›

What are the seven capital budgeting techniques? The seven techniques include net present value (NPV), internal rate of return (IRR), profitability index (PI), payback period, discounted payback period, modified internal rate of return (MIRR), and real options analysis.

What are the 3 methods of capital budgeting? ›

Three popular methods of capital budgeting are net present value (NPV), internal rate of return (IRR), and payback period. These methods help businesses evaluate the profitability and risk of proposed investments.

What is an evaluation technique? ›

Evaluation techniques are methods that are used to analyze the quality, effectiveness, and accuracy of any product/service/process. Almost all of us have been a part of these evaluation techniques in some way or the other, whether it be reviews, interviews, discussions, or surveys of any product, service, or process.

What is the easiest method of capital budgeting? ›

Payback analysis is the simplest form of capital budgeting analysis, but it's also the least accurate. It is still widely used because it's quick and can give managers a "back of the envelope" understanding of the real value of a proposed project.

What are the five 5 steps in capital budgeting? ›

Five Steps to Capital Budgeting
  • Identify and evaluate potential opportunities. The process begins by exploring available opportunities. ...
  • Estimate operating and implementation costs. The next step involves estimating how much it will cost to bring the project to fruition. ...
  • Estimate cash flow or benefit. ...
  • Assess risk. ...
  • Implement.

What is the first step in the capital budgeting evaluation process? ›

The first step in the capital budgeting process is identifying investment opportunities. Once the opportunities are identified, the company's capital budgeting committee identifies the expected sales. The investment opportunities that are aligned with the sales targets are identified.

What is the technique for making capital budgeting decisions? ›

Preparing a Capital Budgeting Analysis
  • Step 1: Determine the total amount of the investment. ...
  • Step 2: Determine the cash flows the investment will return. ...
  • Step 3: Determine the residual/terminal value. ...
  • Step 4: Calculate the annual cash flows of the investment. ...
  • Step 5: Calculate the NPV of the cash flows.

What is the DCF method of capital budgeting? ›

Discounted cash flow (DCF) is an analysis method used to value investment by discounting the estimated future cash flows. DCF analysis can be applied to value a stock, company, project, and many other assets or activities, and thus is widely used in both the investment industry and corporate finance management.

What are capital budgeting analysis techniques applicable to? ›

Capital budgeting is applicable to everything from purchasing a new piece of machinery to building a new facility. In general, capital budgeting focuses on cash flows rather than profits. It's intended to reveal which project's net cash flow has more value after expenses have been subtracted.

What are the methods of evaluating capital structure? ›

In evaluating a company's capital structure, the financial analyst must look at such factors as the capital structure of the company over time, the business risk of the company, the capital structure of competitors that have similar business risk, and company-specific factors (e.g., the quality of corporate governance, ...

What is the method for evaluating capital investment? ›

The most common capital investment evaluation tools are the Payback Period (PP), Return on Investment (ROI), Net Present Value (NPR), and Internal Rate of Return (IRR). Each method can provide insight into investment options, but each also has limitations.

What are the three generally accepted models of evaluating or analyzing capital budgets? ›

Three common methods of capital budgeting are the payback period, net present value analysis and the profitability index.

Which of the following are evaluated through the capital budgeting process? ›

Answer and Explanation: The answer is: (e) size, timing and risk of future cash flows. Capital budgeting includes the evaluation of several factors including size, timing of future cash flows and risk depending on the technique used.

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