Capital Budgeting

Collection of cash flow information is essential for the evaluation of investment proposals. The key is to measure incremental cash flows with and without the investment proposal being analyzed. Depreciation under the accelerated cost recovery system (ACRS) in conjunction with the investment tax credit has a significant effect on the pattern of cash flows and, hence, on present value. Also affecting the pattern of cash flows is the presence of salvage value and a working capital requirement. An additional refinement involves company projects with uneven economic lives.

Capital budgeting methods, including the average rate of return and payback methods, were evaluated under the assumption that the acceptance of any investment proposal does not change the business risk complexion of the firm as perceived by suppliers of capital. The two discounted cash flow methods, internal rate of return and net present value are the only appropriate means by which to judge the economic contribution of an investment proposal. The important distinctions between the internal rate of return method and the present value method involve the implied compounding rate, the scale of investment and the possibility of multiple internal rates of return. Depending upon the situation, contrary answers can be given with respect to the acceptance of mutually exclusive investment proposals. On theoretical grounds, a case can be made for the superiority of the present value method, though in practice the IRR is popular.

Capital rationing is likely to result in investment decisions that are less than optimal. Inflation creates a disincentive for capital investment because depreciation charges do not reflect replacement costs, and a firm's taxes grow at a faster rate than inflation. In estimating cash flows, one should take account of anticipated inflation. Otherwise a bias arises, and there is a tendency to reject some projects that should be accepted. This bias was illustrated.

Although the capital budgeting methods discussed here appear to be exact, we are able only to approximate the true value of an investment proposal to the firm. The meaningfulness of the values we calculate is only as good as our cash flow estimates and the required rate of return employed.