Capital Budgeting: Methods and Stages for Long-Term Planning
Capital Budgeting: Methods and Stages
1. What is Capital Budgeting?
Capital budgeting is long-term planning for projects. The life of a project is generally more than one year, so the capital budgeting decision considers cash inflows and outflows for long periods. Accrual accounting measures profitability on a year-by-year basis.
2. What are the Stages of Capital Budgeting?
The six stages are:
- Identification
- Search
- Information Collection
- Selection
- Financing
- Implementation and Control
3. Discounted Cash Flow Methods and Their Advantages
The two main methods are the Net Present Value (NPV) method and the Internal Rate of Return (IRR). NPV calculates the expected monetary gain or loss of a project by discounting all expected future cash inflows and outflows to the present time using the required rate of return. A project is acceptable if the NPV is positive. The IRR method calculates the rate of return (discount rate) at which the present value of expected cash inflows from a project equals the present value of expected cash outflows. A project is acceptable if its IRR exceeds the required rate of return. NPV is the best approach to capital budgeting.
4. What is the Payback Period Method?
This method measures the time needed to recover the initial investment as net future cash income. The payback period method does not consider cash flows after the payback period or the time value of money.
5. What is the Accrual Accounting Rate of Return (AARR)?
The AARR divides an accrual accounting measure of a project’s average annual income by an accounting measure of its investment. AARR considers profitability but not the time value of money.
6. Conflicts Between Capital Budgeting and Performance Evaluation
Using accrual accounting to evaluate a manager’s performance can create conflicts when using Discounted Cash Flow (DCF) for capital budgeting. Often, the decision that yields good operational results in the project’s early years using a DCF method may not align with accrual accounting. For this reason, managers are tempted to use DCF methods, even though decisions based on them would be in the best long-term interests of the company. This problem can be reduced by evaluating managers on a project-by-project basis, considering their ability to meet the amounts and timing of budgeted cash flows.
7. Relevant Cash Inflows and Outflows for Capital Budgeting
Relevant cash inflows and outflows for DCF analysis are the differences in expected future cash flows resulting from the investment. Only cash inflows and outflows are important; accrual accounting methods are irrelevant to DCF. For example, income tax saved due to depreciation deductions is relevant because it reduces cash outflow, but depreciation itself is not a cash outflow.