Investing capital to expand a company or increase a product line requires capital budgeting. Capital budgeting is the process of allocating funds to investment in assets. There are many opportunities for investment available to businesses. Management must evaluate each of these opportunities because some are potentially profitable while others may cause the company to take a hit financially.
Thankfully, there are four common methods used to evaluate investment opportunities. These methods are payback, internal rate of return, net present value and accounting rate of return.
This method evaluates a potential investment by the length of time it will take to recover the investment. Yet, this is not an adequate method for evaluating risk. It does not consider the lifetime of the investment and it denies the time value of money. Money to be recovered 7 years from now does not have the same dollar value as it does at the time it is invested.
This method is the effective rate of interest that equally values the cash returns to be received with the cash outlay of an investment. Unlike the payback method, the internal rate of return takes into account both the lifetime of the investment and the time value of money.
A minimum required rate of return is first decided before the calculation is made. With this rate, the present value of the cash return is calculated. If the present value of the return is greater than the cash outlay of the investment, the investment is considered satisfactory.
This method is expressed as a percentage. The annual incremental net income is divided by the average investment.