Three Analysis Tools For Capital Budgeting Decisions

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Capital budgeting (also known as investment assessment) is the process of determining if an organization’s long-term investments, such as new machinery, replacement machinery, new facilities, new products, and research and development initiatives, are worthwhile (Heisinger & Hoyle, n.d.).

Managers must consider the possible risks of the investment not performing as expected for a variety of reasons when embarking on this planning process (Lumen Learning, n.d.). As a result, analysis in capital budgeting is critical for identifying, evaluating, and identifying solutions to diverse circumstances. Failure to do a good analysis for capital budgeting decisions might jeopardize the company’s investment outcome (Heisinger & Hoyle, n.d). Therefore, we need to choose the appropriate method to perform capital budgeting decisions. According to Heisinger & Hoyle (n.d.), a frequent way of decision-making is to calculate the Net Present Value (NPV), as well as the Internal Rate of Return (IRR) and Payback Period (PP).

Three Analysis Tools For Capital Budgeting Decisions

1. NPV: The Net present value (NPV) technique adds up all cash inflows and subtracts all cash outflows linked with a long-term investment (Accounting Tools, 2022). The NPV may alternatively be defined as the difference in present value between the invested investment and future cash inflows (Heisinger & Hoyle, n.d.). Heisinger & Hoyle (n.d.) also stated that investments are permitted when the NPV exceeds or equals zero; otherwise, the investment is refused. The net present value (NPV) approach is the most analytical and exact capital budgeting evaluation strategy. Unlike the IRR method, NPVs reveal how advantageous a project will be in comparison to alternatives.
2. IRR: The Internal Rate of Return (IRR) for a sequence of cash flows is the rate required to get an NPV of zero. When the IRR exceeds or equals the firm’s needed rate of return, the investment is acceptable, and vice versa (Heisinger & Hoyle, n.d.). However, the IRR does not offer a project’s true worth and does not allow for the accurate evaluation of mutually constrained initiatives (Pinkasovitch, 2022).
3. Payback Methods: The payback method calculates the time necessary to recoup an original expenditure and is commonly expressed in years (Heisinger & Hoyle, n.d.). According to Pinkasovitch (2020), one of the drawbacks of the payback method is the payback period does not account for the time value of money. This problem, however, may be solved by implementing a low-cost payback time model.

Which Method Provides The Best Information And The Least Beneficial Information?

Based on the previous analysis, I think the method that provides the best information is the NPV method because the NPV analysis, clearly compares the expected budgeted cash flow to the required rate of return (Heisinger & Hoyle, n.d.). While method that gives the least beneficial information is the IRR method, since the cash flow flows from a project are not conservative, like future capital layout for repair and maintenance. In addition, the IRR does not offer a project’s true worth and does not allow for the accurate evaluation of mutually constrained initiatives.

Conclusion

To summarize, the management needs to use various tools and cannot rely on only 1 method since each of the methods has its own drawbacks. The combination of at least three of the common methods (NPV, IRR, and Payback) can be effective tools for the management in making decisions for their capital budgeting.

References

Accounting Tools. (2022, April 23). Present value definition — AccountingTools. AccountingTools. Retrieved July 26, 2022, from https://www.accountingtools.com/articles/present-value

Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html

Lumen Learning. (n.d.). The relationship between risk and capital budgeting. Boundless Finance. https://courses.lumenlearning.com/boundless-finance/chapter/the-relationship-between-risk-and-capital-budgeting/

Pinkasovitch, A. (2022, January 27). An Introduction to Capital Budgeting. Investopedia. Retrieved July 27, 2022, from https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp

Note:
This article is written based on University of The People Managerial Accounting (BUS 5110) written assignment by Fristy Tania in July 2022