THE FOUR MAIN CAPITAL BUDGETING

TECHNIQUES
Most organizations use one or more of the following four techniques to help determine whether a capital investment is
worth making. Here’s a quick run-down, including the pros and cons of each.

1. Net Present Value (NPV)

Net Present Value (NPV) represents the current value of future cash flows. It tells you how much cash the
investment will generate versus how much must be spent to make the investment, in current and future dollars.

You compute each year’s cash flow separately:

CF1 CF2 CFn

Net Present Value = Cash flow (CF )0 + + +...+
( 1+i )1 ( 1+i )2 ( 1+i )n
CF = a future cash flow
n = number of years of the cash flow
i = interest rate

PROS: Takes inflation and foreign exchange rates into account, calculates all the inflows and outflows over time;
represents the final value to the company in today’s currency amounts. Preferred because it is most accurate.

CONS: More complex to compute.

2. Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is a percentage that is used to compare a potential investment against the hurdle rate
to determine whether it’s worthwhile. Basically with IRR, you divide estimated profit by estimated expenditure.

Estimated profit
Internal Rate of Return =
Estimated expenditure

If the result exceeds the hurdle rate, the investment is worth pursuing. The higher the IRR, the more profitable the
project.

IRR is the rate at which the NPV of an investment equals zero. IRR uses the same formula as NPV, but sets the NPV
at zero, so you are solving the equation for rate of return. (In calculating NPV, you know the desired rate of return,
and you’re solving the equation for the NPV of future cash flows.)

PROS: Enables companies to assess returns on an annual basis. Considers the time and value of money. Easier for
many to understand returns expressed in percentages, especially in comparing to the cost of capital.

CONS: Like NPV, complex to compute. Can’t be used in cases where cash flows change (inflows, then outflows).

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THE FOUR MAIN CAPITAL BUDGETING
TECHNIQUES

3. Profitability Index
Profitability Index represents the relationship between the costs of a potential project and its estimated benefits.

Current value of future cash flows

Profitability Index =
Initial investment

If the ratio is less than 1.0, the investment costs outweigh the expected returns. If it is greater than 1.0, the returns
exceed the cost. The higher the index value, the more attractive the project.

Similar to NPV method, the profitability index lets you compare the profitability of two investments without regard
to the amount of money invested in each.

PROS: Favors small projects; best suited for firms with limited resources and high cost of capital.

CONS: Not as precise as NPV.

4. Payback Period
Payback Period is the length of time it will take to recoup an investment. This is the formula for determining it:

Total amount of investment

Payback Period =
Annual new revenues (or savings)

A period of 1 means it will take one year to recoup the investment.

PROS: Simple technique.

CONS: Ignores the time value of money; is biased toward products or services that generate most of their money
on the front end. Used less frequently today.

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