Capital Budgeting Technique
MGMT-3004-04 Financial Management
Capital Budgeting Techniques
Capital budgeting is one of the most important decisions that face a financial manager. There are many techniques that they can use to facilitate the decision of whether a project or investment is worthy of consideration. The four that will be covered within this paper are Payback Rule, Profitability Index, IRR and NPV. Each method has its strength and weaknesses and they will be examined to determine which method is superior to the rest.
The first method to look at is Payback Rule. This rule is designed to show how long it will take to recover the cost of investment for the firm. This investment rule specifies a certain number of periods as a cutoff for determining whether to invest in a project. All investment projects where the initial investment cannot be recovered in specified cutoff period are unacceptable under this rule no matter what they provide past the cutoff. It is the easiest of all the methods to use and understand that will be reviewed. An example of this method is list in table 1. Now if we look at this table we find that if we use two periods as the cutoff then only Project B would be accepted for Project A does break even until year three. The problem with this method is that Project B breaks even but does not provide any income for the firm where Project A would in year three.
C0 C1 C2 C3 NPV at 10%
Project A -1000 800 150 250 39.06
Project B -2500 1200 1300 0 -334.71
Table 1
The next method to review is Profitability Index. The profitability index is defined as PI = -PV/C0. This method was ranked as next to the lowest in 2003 survey with only APV below it. (Financial Executive'S News, 20 ...