1.11 Critical Methodological Issues Relative to Choice of Capital Budgeting Technique
On the pages to follow, we will present and evaluate various analytic capital budgeting techniques; so far, we have only presented and critiqued the (two) payback methods. In considering the method by which the analyst will evaluate a proposed capital investment project, s/he needs to consider whether the technique employed properly considers each of the following relevant analytic considerations, which are presented once again in review.
The Time Value of Money – Does the method properly utilize TVM? We know that nominal cash flows cannot be evaluated on an even plane!
Cash flows (or profits) after payback – Does the method consider all possible, projected cash flows? It is possible that one may choose a four-year payback versus a five-year alternative, but the five-year possibility provides substantially more cash inflows after the payback? This could lead to a poor choice.
Scale of the Project – Even though one project may be preferred to another in terms of, say, its discounted payback, a one-million-dollar investment with a longer payback may be preferred to a one-thousand-dollar project with a shorter payback. The larger project, simply put, may provide greater profits and/or cash flow. This issue was not discussed above.
Rate of Return (ROR) – in Finance, we typically discuss or evaluate investments in terms of an ROR; that is our language. For example, if I am considering putting money in the bank, the banker will provide me with a quote stated in percentage terms. Percentages provide a manner in which alternatives may be objectively compared.
Risk – The principal risk is that the actual cash flows don’t come in as projected. The FCF projections are uncertain. In fact, the more distant cash flows are less certain than the earlier ones. To deal with this contingency, the analyst may use probability or sensitivity analysis to give some “color” to the projections – prior to subjecting the projections to a capital budgeting test. We will not deal with that (advanced) approach herewith and instead will view the projections as though they are certain.