Capital Budgeting Techniques

Case Study UNIT VII – Capital Budgeting Techniques

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Capital Budgeting Techniques

This paper will explore the various method or techniques of capital budgeting as well as compare and contrast their strengths and weaknesses. Capital budgeting is the process used by organizations to make decisions about whether long-term investments worthiness or capital expenditures are worth pursuing (Baker, 2011). In simple terms, it is the process of planning, analyzing, selecting, and managing capital investments (Baker, 2011). Although there are several techniques available for evaluating capital budgeting for projects acceptance, the best techniques identify the amount, the time value, and the risk factor of a project’s cash flows (Baker, 2011). Four of the more popular and most useful techniques that this paper will focus on are payback period, net present value (NPV), internal rate of return (IRR), and profitability index (IP).

The first of the four techniques to review is the payback period method. Referred to as the “breakeven” point, the payback period technique is known as the simplest of the four as its only consideration is the length of time it will take to repay the initial investment (Mian, 2011). When considering independent projects the rule of acceptance is, “an acceptable project’s payback period must be less than that policy maximum, which is typically three years” (Lasher, 2011, p. 459). While when considering mutually exclusive projects the rule is the shorter the better.

Although simplistic in its approach, the payback technique has its weaknesses. Its simple approach has two flaws; it ignores the time value of money as well as cash flow after the payback period (Lasher, 2011). On the other hand, the strength of the payback period is that is a good method for screening a project. If a project fails the payback period technique it should be passed on and if it passes, a more...