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.

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.