Capital budgeting techniques are utilized for the purposes of ensuring that the purchases of any fixed asset made by the company offer greater benefits to the company than the associated costs of those fixed assets while ensuring that there is a set amount of money available for the purchase of those fixed assets (Capital Budgeting Techniques, n.d.). There are three primary types of capital budgeting techniques that may be utilized by an organization: payback periods, net present value (NPV), and internal rate of return (IRR), though it is possible for an organization to use any combination thereof (Marzec, 2013).
There are pros and cons associated with the use of applying these different techniques when attempting to make wealth maximizing decisions associated with the investment of corporate funds. The IRR is less accurate than the NPV, but it serves to provide the easiest method of determining whether the fixed asset is worthwhile through the use of simple percentages of cost versus returns (Marzec, 2013). The NPV, a far more complex process that deals with potential cash flows of the organization as a result of the fixed assets may be more accurate, though it requires a long term assessment of all assets and a far more complex determination process (Marzec, 2013). The payback period is typically utilized in conjunction with one of the other methods as it simply states how long the company will take to recover from a purchase, making it not as efficient on its own, but an ideal option to utilize in conjunction with the others (Marzec, 2013). If the company were to simply apply one principle of capital budgeting to all their decisions, however, the result could be disastrous, as there is a large difference between the costs associated with software upgrades and the cost associated with the decision to purchase a new building, potentially resulting in an inaccurate or invalid assessment for the business.
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"Principles of Finance: Discussion Week 10: Capital Budgeting and Capital Structure".
The most efficient capital structure for a manufacturing company would be NPV due to the fact that a manufacturing company has a large amount of large fixed assets, associated primarily with the manufacturing process. A software development firm, on the other hand, would likely utilize the payback period due to the fact that while software upgrades are mandatory, the upgrade process results in only a temporary setback to total capital.
- Campus.murraystate.edu. (n.d.). Capital budgeting techniques. [online] Retrieved from: http://campus.murraystate.edu
- Marzec, E. (2013). Three primary methods used to make capital budgeting decisions. [online] Retrieved from: http://smallbusiness.chron.com/
