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Capital budgeting techniques in practice

Introduction

Movements in capital spending are often industry-wide occurrences and amass to very large sums.  In fact, total spending on new and used structures and equipment (i.e., capital spending) by all U.S. nonfarm businesses have been around a trillion dollars annually from 1999 to 2008 according to the US Census Bureau – 2007 and 2008 are about $1.3 trillion each. Clearly, these investments are among the most scrutinized decisions in business. So, how are they made and which is best?

Which is best?

When it comes to making an investment decision in capital spending, there are three basic kinds of criteria as shown in the table below: 1) discounted cash flow criteria, 2) payback criteria, and 3) accounting criterion.

This post provides a view of historical and current best practice.

Discounted Cash Flow Criteria Payback Criteria Accounting Criterion
  • Net present value (NPV)*
  • Internal rate of return (IRR)
  • Modified internal rate of return (MIRR)
  • Profitability index (PI)
  • Payback period
  • Discounted payback period
  • Average accounting return (AAR)

Note: *NPV is Preferred; Please look up basic definitions and examples for each of these capital budgeting procedures if needed.

Among these capital budgeting procedures, NPV is preferred for a number of reasons that require a much longer discussion than this one. Basically, NPV acknowledges risk, the time value of money, and cash flows beyond any set cutoff point other than years in consideration.

A look at historical use along with a brief discussion should provide enough context as to why NPV is dominant. Let’s begin.

Historical Comparison of the Primary Use of Various Capital Budgeting Techniques

The table below shows the historical popularity of employing a few key techniques from 1959 to 1981. One notices that NPV emerges only around 1975 and by 1981 is used 16.5% of the time. Together with IRR, these two techniques dominate, representing 81.8% of use by 1981.

Technique 1959 1964 1970 1975 1977 1979 1981
Payback period 34% 24% 12% 15% 9% 10% 5.0%
Average accounting return (AAR) 34 30 26 10 25 14 10.7
Internal rate of return (IRR) 19 38 57 37 54 60 65.3
Net present value (NPV) 26 10 14 16.5
IRR or NPV 19 38 57 63 64 74 81.8

Percentage of CFOs Who Always or Almost Always Used a Given Technique in 1999

With increased sophistication and emerging best practices, about 75% of CFOs were always or almost always using IRR or NPV in 1999. However, it’s worth noting that payback period was used about as much as NPV and IRR among small firms.

Technique Always or almost always using (%) Overall Avg Score Large firms Small Firms
Internal rate of return (IRR) 76 3.09 3.41 2.87
Net present value (NPV) 75 3.08 3.42 2.83
Payback period 57 2.53 2.25 2.72
Discounted payback period 29 1.56 1.55 1.58
Accounting rate of return 20 1.34 1.25 1.41
Profitability index (PI) 12 0.83 0.75 0.88

Note: Scale for score was 4 (always) to 0 (never). 392 CFOs of small and large firms responding to 1999 survey.

A deeper look at why (quickly)

When comparing projects, the project with the highest IRR is NOT necessarily the preferred investment! Moreover, one cannot use IRR to rank projects that are mutually exclusive. Additionally, projects with unconventional cash flows may have more than one IRR or no IRR.

That said, IRR is closely related to NPV and will lead you to the same decisions as using NPV for conventional, independent projects.

Closing comments

Predicting the future often leads to “soft” estimates to say the least. A variety of measures and techniques are used to determine the reliability of a given calculated NPV. While no single measure should ever be used as THE sole determining factor in these decisions, some methods are better than others.

References

Graham, J.R. and Harvey, C.R. “The Theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics, May-June 2001, pp. 187-244.

Moore, J.S. and Reichert, A.K. “An Analysis of the Financial Management Techniques Currently Employed by Large U.S. Corporations,” Journal of Business Finance and Accounting, Winter 1983, pp. 623-45

Ross, S. A. Westerfield, R. W. & Jordan, B. D. (2008). Fundamentals of Corporate Finance (8th edition). New York: McGraw Hill.

Stanley, M.T. and Block, S.R.”A Survey of Multinational Capital Budgeting,” The Financial Review, March 1984, pp. 36-51.

US Department of Commerce: Bureau of the Census, (2010). Annual Capital Expenditures Survey (ACES). Retrieved July 20, 2010, from http://www.census.gov/econ/aces/report/2010/capitalspendingreport2010.pdf

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