Capital Budgeting Models

There are a number of capital budgeting models available that assess and rank capital expenditure proposals. Let’s take a look at four of the most common models for evaluating business investments:

  • Accounting rate of return

  • Payback

  • Net present value

  • Internal rate of return

While each of these models has its benefits and drawbacks, sophisticated financial managers prefer the net present value and the internal rate of return methods. There are two reasons why these models are favored: (a) all of the cash flows over the entire length of the project are considered, and (b) the future cash flows are discounted to reflect the time value of money.
The following table highlights the differences among the four models:

Method

Information Used

Time Period Covered

Accounting Rate of Return

Accrual Accounting Amounts

Average of All Years or a Specific Year

Payback

Cash Flows – Not Discounted

Until Cash is Recovered

Net Present Value

Discounted Cash Flows

Entire Life of Project

Internal Rate of Return

Discounted Cash Flows

Entire Life of Project