Capital Budeting

An Introduction To Capital Budgeting

By Arthur Pinkasovitch AAA | 

Capital budgeting involves choosing projects that add value to the firm. This can involve almost anything from acquiring a lot of land to purchasing a new truck or replacing old machinery. Businesses, specifically corporations, are typically required, or at least recommended, to undertake those projects which will increase profitability and thus enhance shareholders' wealth.

Tutorial: Financial Concepts and Capital Budgeting

When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The net present value (NPV), internal rate of return (IRR) and payback period (PB) methods are the most common approaches to project selection. Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on managements' preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantage associated with these widely used valuation methods.

Payback Period

The payback period calculates the length of time required to recoup the original investment. For example, if a capital budgeting projects requires an initial cash outlay of $1 million, the PB reveals how many years are required to for the cash inflows to equate to the one million dollar outflow. A short PB period is preferred as it indicated that the project will "pay for itself" within a smaller time frame.

In the following example, the PB period would be three and one-third of a year, or three years and four months.

Investment | Inflows |

Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |

-1,000,000 | 300,00 | 300,000 | 300,000 | 300,000 | 300,000 |

Payback periods are typically used when liquidity presents a major concern. If a company only has a limited...