Capital Budgeting
Capital budgeting is one of the most critical aspects of sound financial management that all executive management teams must be able to conduct for their companies on a regular basis. Regardless of the number of employees, revenue streams, or total investors, each company’s executive panel must be able to effectively manage financial resources in such a way so as to maximize the company’s market value, and consequentially their shareholders’ wealth. The process of capital budgeting requires that management teams investigate, evaluate, and ultimately determine which business endeavors and projects will add value to their respective firms and to their investors. Managers that make erroneous capital budgeting decisions risk the long-term profitability and perhaps solvency of their companies. Thus, while the analytical tools and measures typically used to evaluate investment decisions under the capital budgeting process seem rather simplistic upon casual view, a more investigative examination of these tools is required to illustrate their complexities and relative strengths and weaknesses for managers faced with such significant responsibilities.
Scope of Report
The remainder of this report focuses on five of the most commonly used methods for evaluating proposed projects, investment decisions, and business endeavors that managers use in the capital budgeting process. These five methods of capital budgeting are referred to as: payback (and discounted payback) period (DPB), net present value (NPV), profitability index (PI), internal rate of return (IRR), and modified internal rate of return (MIRR). For each budgeting method, a brief description along with formula for calculation is provided. Also, each method’s relative strengths and weaknesses are examined. Following those observations, recent scholarly research related to the accuracy of the theoretical assumptions underlying NPV, IRR, and MIRR are discussed. Concluding this report is a recommendation for which methodology of capital budgeting managers should use given the prior analysis of relative strengths and weaknesses and recent findings from the academic community.
Payback Period and Discounted Payback Period Method(s) (PB and DPB)
The discounted payback period method is a derivative of the payback period method. The payback period is found by adding individual expected net cash flows for each period to the initial cash outflow (Parrino & Kidwell, 2009). Thus, the payback period is the number of years, or periods, that it takes a company to recoup its initial investment in a project. A project with a shorter payback period is preferred to a competing project with a longer payback period, assuming both are of equivalent risk, as a company wants a return of its initial capital outflow as soon as possible given the nature of the time value of money. Stated alternatively,