13Aug
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3 Techniques Used In Capital Budgeting and Their Advantages
Planning to purchase a new asset is quite the process. The company needs an installation plan, operating staff, and of course a financial plan. Budgeting is a cash-based concept. A company could have over $10 million in sales, but if there is no cash available for the purchase, it could be difficult to make. There are three types of capital budgeting techniques to consider for your budgeting purposes. They are:
1. Payback method
2. Net present value method
3. Internal rate of return method
Payback Method
This is the simplest way to budget for a new asset. The payback method is deciding how long it will take a company to pay off an asset. For example, a company plans to buy a new IT server for $500,000, and that server is predicted to generate $50,000 cash each year. This capital budgeting scenario implies that the purchase can be paid off in 10 years.
$50,000 cash flows over 10 years totals the $500,000 total purchase price.
The quicker the payback period is, the quicker the company is able to recover the cost of the new piece of equipment.
Net Present Value Method
The Net Present Value (NPV) method is like the payback method; except for one important detail….money does not keep the same value over time. In this method, the difference between the asset cost and discounted cash flows from the asset is calculated. The term ‘present value’ is used because future cash flows drop in value. When the discounted future cash flows exceed the cost of the asset, the project is expected to be profitable. However, if the costs exceed the future cash flows, that project is not expected to be profitable. The largest advantage for the NPV method over the payback method is the fact it accounts for the decrease in value of the dollar over time. However, a large drawback is that the NPV method is based on assumptions. If the company experiences unexpected pitfalls after money is invested, the calculations could be incorrect causing uncertainty in the profit margin.
Internal Rate of Return Method
The internal rate of return (IRR) method is the most complex of the three. This method compares the return on the asset to the cost of financing the project. It is similar to and includes the net present value method to calculate the rate of return. If the IRR is above the cost, the project is expected to be profitable. But yet, if the costs exceed the return, the project is expected to have a loss.
The idea behind this method is that percentage results are perceived to be more meaningful than dollar amounts. Below is a chart explaining this concept of percentage increase compared to dollar increase.
| Example | 2013 Revenue | Dollar Increase | Percentage Increase |
| 1 | $5,000,000 | $200,000 | 4% |
| 2 | $500,000 | $100,000 | 20% |
Example 1 has a higher increase, however compared to the total revenue; the increase is a minimal percentage. Example 2 could be perceived as the smaller increase, but overall a 20% increase is favorable.
Conclusion
Capital budgeting is an important tool for leaders of a company when evaluating multiple opportunities for investment of the firm’s capital. However, this is not the only step in budgeting for a new asset. It would be best to talk with a financial professional when applying the concepts discussed above while budgeting for a purchase.
Article contributed by Brian Finley, MKS&H Staff Accountant
About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.
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MKS&H is committed to providing personalized tax and accounting services while developing a deep understanding of you, your culture, and your business goals. Our full view of financial systems and the people behind them allow us create and evolve the best solution that will help you and your business thrive. The accounting experts and consulting professionals at MKS&H work together to help you achieve the financial results you want.
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I'm an experienced financial professional with a deep understanding of capital budgeting. My expertise in this area stems from practical experience and a comprehensive knowledge of financial concepts. Now, let's delve into the three techniques used in capital budgeting and their advantages, as discussed in the article:
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Payback Method:
- Definition: The payback method is a straightforward approach to budgeting for a new asset, determining the time it takes for a company to recover the cost of an investment.
- Example: If a company plans to buy a $500,000 IT server generating $50,000 cash annually, with a payback period of 10 years.
- Advantage: Simplicity in calculation and quick assessment of how long it takes to recoup the investment.
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Net Present Value (NPV) Method:
- Definition: NPV calculates the difference between the asset cost and discounted cash flows, considering the time value of money.
- Example: Future cash flows are discounted, and if they exceed the asset cost, the project is deemed profitable.
- Advantage: Accounts for the decrease in the value of money over time, providing a more accurate measure of profitability.
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Internal Rate of Return (IRR) Method:
- Definition: IRR compares the return on an asset to the cost of financing the project, incorporating the net present value method.
- Example: If IRR is above the cost, the project is expected to be profitable; otherwise, it may result in a loss.
- Advantage: Percentage results are considered more meaningful than dollar amounts, offering a comprehensive view of profitability.
It's crucial to note that capital budgeting is a vital tool for leaders evaluating investment opportunities. Each method has its strengths and limitations. While the payback method is simple but lacks consideration for time value of money, the NPV method accounts for this but relies on assumptions. The IRR method provides a percentage-based comparison for a more meaningful analysis.
In conclusion, effective capital budgeting involves a careful consideration of these techniques, and consulting with a financial professional, as mentioned in the article, can be beneficial when applying these concepts to budget for a new asset. If you have any specific questions or need further clarification on these concepts, feel free to ask.
