Handbook of Finance: Investment Management and Financial Management

Chapter 67. Capital Budgeting Techniques

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

PAMELA P. DRAKE, PhD, CFA

J. Gray Ferguson Professor of Finance and Department Head of Finance and Business Law, James Madison University

Abstract: There are several techniques that are used in practice to evaluate capital budgeting proposals. These include the payback and discounted payback techniques, net present value technique, profitability index technique, internal rate of return technique, and modified internal rate of return technique. While used in practice, some of these techniques are limited in their ability to help managers identify proposed capital projects that are profitable and are not necessarily consistent with maximization of shareholder wealth. Moreover, where capital rationing exists, some techniques give conflicting rankings of the relative attractiveness of capital projects.

Keywords: capital budgeting techniques, net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, modified internal rate of return (MIRR), profitability index, mutually exclusive projects, independent projects, capital rationing, cost of capital, required rate of return (RRR), crossover discount rate, hurdle rate

The value of a company today is the present value of all its future cash flows, where these future cash flows come from assets that are already in place and from future investment opportunities. These future ...