Capital Budgeting Techniques and Cash Flow Determination

BUSINESS FINANCE
Capital Budgeting
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Introduction
Capital budgeting is a widely used concept in decision making particularly with regards to
capital allocation. This is required since there may be multiple projects which may be
profitable and feasible but the financial and other resources are typically limited. As a result,
the company needs to select the projects and allocate resources to those which would lead to
wealth maximisation for the shareholders of the company. In order to evaluate the underlying
financial feasibility and the wealth generation potential of various projects, there are certain
capital budgeting techniques that are deployed which need to be critically analysed. The
application of the capital budgeting techniques is contingent on the computation of cash
flows which need certain factors to be considered. Also, it is noteworthy that there is risk
involved in capital budgeting owing to uncertainty with regards to future cash flows which
needs to be captured through various methods.
Analysis of Capital Budgeting Techniques
One of the most common techniques of capital budgeting is net present value which is also
known as NPV. This method involves the determination of present value of the future cash
flows estimated from the project under consideration. In order to compute the present value, a
crucial assumption is taken as per which all the relevant cash flows in a given year tend to
occur at the end of the year which would not be true in real life and hence deviation from
NPV is expected (Parrino & Kidwell, 2014). A crucial input with regards to computation of
NPV is discount rate whose determination is quite often tricky. This is because it is not only
dependent on the respective project funding but on the risk assessment of the project in
comparison with the firm. This should be carefully performed so as to accurate estimate the
discount rate as NPV is known to be quite sensitive to discount rate (Damodaran, 2015).
A key advantage of NPV is that it considers the time value of money which is a crucial
aspect. This is because there is opportunity cost associated with money and the same needs to
be considered. Also, the results produced by NPV analysis are highly reliable and facilitates
project selection for wealth maximisation of shareholders (Shinoda, 2010). Unlike some other
techniques, the NPV analysis tends to provide consideration to the cash flows during the
whole project unlike some other techniques which tend to consider the cash flows only for
part of the project period Freeman & Hobbes, 2016). However, NPV analysis does have some
shortcomings. One of these is that a complete forecasting of the incremental costs and
incremental benefits over the project period would be necessary which quite often is not easy

and thereby may lead to incorrect computations. Also, this method is not easy for non-finance
based managers to understand as the time value of money concept is involved (Dragota et. al.,
2010).
Another capital budgeting measure is Internal Rate of Return or IRR. It is defined as the
underlying discount rate for which the project NPV becomes zero. Unlike NPV, the
computation of IRR is not based on the discount rate and is essentially independent of the
same. The decision rule in IRR requires comparison to the discount rate of the project as the
project is acceptable if the IRR exceeds the discount rate (Damodaran, 2015). However, if
IRR is less than the project discount rate, then the project is not considered feasible. Most of
the advantages of this method are similar to NPV considering the accuracy, consideration of
complete cash flows and time value of money (Singh, Jain and Yadav, 2012). Additionally,
IRR is simpler to understand in comparison to NPV and is essentially expressed in % form
which facilitates comparison. However, IRR tends to provided multiple answers when net
cash outflow tends to occur during the project (Freeman and Hobbes, 2016). Also, in case of
projects being of different size, then IRR cannot be used as an appropriate ranking tool.
Further, hit and trial method needs to be applied though the same can be eliminated using
various statistical tools (Daunfeldt & Hartwig, 2011).
An alternative technique available for capital budgeting is payback period. This refers to the
period required for the recovery of the initial investment that was undertaken for the project.
Further, the undiscounted cash flows are taken for the computation of this metric. One of the
key advantages which prompt the usage of this method is that this technique is quite easy to
apply (Brealey, Myers & Allen, 2014). However, there are certain issues with payback period
which make IRR and NPV superior. One of these relate to ignoring the time value of money
since the undiscounted cash flows are used. Another issue is that the payback period does not
consider the cash inflows or outflows that tend to occur after the payback period (Parrino &
Kidwell, 2014). Further, it does not highlight how the shareholders’ wealth would be altered
by accepting the project. Owing to the above shortcomings, payback period is rarely used as a
standalone capital budgeting measure and is often used as a complementary measure to others
such as NPV & IRR (Andor, Mohanty and Toth, 2015).
Another capital budgeting technique is Accounting Rate of Return or ARR. This tends to
focus on the average annual income that is generated per unit invested capital. Usually firms
tend to define a minimum ARR which they want the projects to meet in order to be