Choosing a Capital Budgeting Technique

Anyone responsible for capital budgeting within a firm should understand how to choose an appropriate capital budgeting technique when making decisions. A number of methods are commonly used to evaluate projects and some are much more telling than others. Primarily, financial managers look to net present value, internal rate of return, modified internal rate of return, profitability index, real options analysis, and the equivalent annuity method to make informed decisions about which projects should be pursued.

Net Present Value

Net present value is the single most powerful metric in capital budgeting, but it requires the most input information to output a useful measure. To find a project’s net present value, the project’s entire series of cash flows and their dates must be determined and then discounted appropriately by the firm’s weighted average cost of capital (WACC). The net present value estimate is highly sensitive to the discount rate (WACC) so any inaccuracy might have a huge impact on the decision factor. With the proper discount rate, the decision to move forward with the project is rather simple: yes if the net present value is more than $0, no if it is less than $0 and indifference if it is exactly $0. This is because net present value represents the amount of money the project will generate for the firm after accounting for all expenses, financing costs, and opportunity costs, priced in today’s dollars.

Internal Rate of Return

The internal rate of return measures the discount rate that matches cash inflows and outflows such that the net present value is 0. To find the IRR, only cash flows are required, so there is no estimation error from having to determine the firm’s proper discount rate like with net present value. Internal rate of return is most useful in what are considered normal situations where the series of payments is either all inflows followed by all outflows or vice versa, otherwise the results are more difficult to interpret. A project should be considered if IRR exceeds the firm’s WACC, and thus it should provide the same decision as net present value as long as the WACC is accurate.

Modified Internal Rate of Return

A project’s internal rate of return does not have very much meaning outside of the investment decision because it assumes cash flows are reinvested at the internal rate of return, which is very rarely the case. The modified internal rate of return corrects for this by assuming an appropriate reinvestment rate and finance rate to provide a figure that estimates the annual profitability of the project. This method is a cross between net present value and internal rate of return and can be used to interpret percentages returns while IRR itself cannot.

Profitability Index

Profitability index is determined by dividing the present value of future cash flows by the initial investment and determining whether it is larger than 1. It is a quick measure of “bang for the buck” in that higher values represent more profits at the same cost. Typically, net present value is preferred.

Real Options Analysis

Financial managers must be concerned with finding or creating real options in projects. These real options could be the ability to expand or contract the project or abandon it altogether before completion, as well as some others. A number of methods are available with varying degrees of difficulty in calculating the value of a real option, which is then added to the net present value calculation and can have a large impact on the investment decision.

Equivalent Annuity Method

When projects do not span the same length of time, net present value is ambiguous in determining the better project since it only considers net dollars generated regardless of time. The equivalent annuity method is used for projects which can be repeated and provides an “annualized” net present value (by dividing net present value by the annuity factor) so that the projects can be compared properly.

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