Capital Budgeting Techniques

Capital budgeting is set of techniques used to decide which investments to make in projects. There are a number of capital budgeting techniques available, which include the following:

Discounted cash flows. Estimate the amount of all cash inflows and outflows associated with a project through its estimated useful life, and then apply a discount rate to these cash flows to determine their present value. If the present value is positive, accept the funding proposal.

Internal rate of return. Determine the discount rate at which the cash flows from a project net to zero. The project with the highest internal rate of return is selected.

Constraint analysis. Examine the impact of a proposed project on the bottleneck operation of the business. If the proposal either increases the capacity of the bottleneck or routes work around the bottleneck, thereby increasing throughput, then accept the funding proposal.

Breakeven analysis. Determine the required sales level at which a proposal will result in positive cash flow. If the sales level is low enough to be reasonably attainable, then accept the funding proposal.

Discounted payback. Determine the amount of time it will take for the discounted cash flows from a proposal to earn back the initial investment. If the period is sufficiently short, then accept the proposal.

Accounting rate of return. This is the ratio of an investment’s average annual profits to the amount invested in it. If the outcome exceeds a threshold value, then an investment is approved.

 Real options. Focus on the range of profits and losses that may be encountered over the course of the investment period. The analysis begins with a review of the risks to which a project will be subjected, and then models for each of these risks or combinations of risks. The result may be greater care in placing large bets on a single likelihood of probability.

When analyzing a possible investment, it is useful to also analyze the system into which the investment will be inserted. If the system is unusually complex, it is likely to take longer for the new asset to function as expected within the system. The reason for the delay is that there may be unintended consequences that ripple through the system, requiring adjustments in multiple areas that must be addressed before any gains from the initial investment can be achieved.