Capital budgeting: Methods, aspects, and issues

This paper is intended to help both business students and practitioners understand the capital budgeting (CB) process. Unfortunately, other than standard university text books, there is a lack of available resource materials for teaching CB. This paper draws the key elements of the subject together, including the underlying purposes for a better understanding of CB and it emphasizes the disposition of the forthcoming cash benefits from projects and/or investment opportunities, when and if they occur. The paper provides flexible tools and example problems for teaching CB in a variety of contexts, such as professional corporate training or academic coursework. CB is used by professionals in all parts of a typical business organization; including, but not limited to, those in manufacturing, research and development, human resources, marketing and advertising, safety, and environmental regulatory compliance. The paper develops and refines CB concepts and methods within the framework of the corporation. To start, the two main reasons for using CB are discussed. First, of the many possible projects available to the firm, CB assists the manager in determining which projects are and are not acceptable from a financial prospective. Second, of those projects deemed financially acceptable, the order or ranking relative to desirability can be established. Next, under conditions of certainty, the paper describes and contrasts three primary or traditional methods; pay back (PB), net present value (NPV), and internal rate of return (IRR). Later on, the same is done for three secondary or nontraditional methods; profitability index (PI), terminal value (TV), and modified internal rate of return (MIRR) for accomplishing the before stated twin CB tasks. The presentation lists the strengths and weaknesses of each method in order to direct attention to some of the many aspects of CB decisions that firm managers should consider. The paper raises the important issues of what to do with the net cash benefits from various projects when and if they are received. The article introduces approaches for taking risk into consideration when using the concepts and methods previously developed. Finally, a group of practice problems, for demonstration purposes, are introduced. The last three of these are multiple IRR answer example problems.