Capital budgeting decisions impact more than just how the company deploys its capital. These decisions -- what fixed assets to acquire or build, when to acquire or build them, and where they should be located -- ultimately define the company itself, because they determine what business the company competes in and how it approaches the market. They influence factors ranging from how many employees the company will hire to the prices it will be able to charge for its goods and services, to the structure of its supply chain, the flexibility of its inventory management system, and the sets of business, economic, and political risks it faces.

Moreover, capital budgeting decisions are closely intertwined with a company's projected and actual revenues: investing decisions must be driven by sales forecasts, but a company's actual level of investment will place a practical limit on its realizable revenues. For example, a restaurant chain will decide to open a new restaurant only if it can be justified by its projected sales, profits, and cash flows, but the chain's total revenues will in the long run be determined largely by the number of restaurants it operates. So the ability to make sound capital budgeting decisions is critical to any company's success. In addition, such decisions cannot be avoided: no company can operate without making investments in fixed assets.

The Decision-Making Process

All capital budgeting decisions include the following three steps:

1. Estimate the cash flows associated with the project. This is the most challenging part of the process because it requires the analyst to think through every possible impact the project will have on the company's future cash flows, as well as the likely timing of those cash flows. The objective is to be able to present, on a timeline, all incremental cash inflows and outflows that are likely to be realized if the company decides to make the investment, but that would not exist if the company does not make the investment. The mechanics of cash flow estimation are beyond the scope of this course, so for our purposes, cash flows will be given.
2. Evaluate the cash flows using one or more decision rules. These decision rules, including payback period, net present value, and internal rate of return, are described in detail in the following sections. They are all straightforward to apply, once a project's cash flows have been presented on a timeline.
3. Decide whether to pursue the project. Each decision rule is designed to suggest to the analyst one of three possible conclusions: accept the project, reject the project, or be indifferent to the project.

Topic 9.2 Capital Budgeting Decision Rules

Payback Period

Payback period is simply the length of time required for an investment to generate cash inflows that recover its initial (cash outflow) cost.

Example 9.2.1

Assume that a brewery is considering an investment in new brewing equipment that will enable it to produce a line of fruit-infused beers, and that the cash flows associated with this project are estimated as shown in the table below. The initial cash outflow of $100,000 represents the initial investment in brewing equipment, while future positive cash flows are the expected return on investment as beer drinkers begin to switch to fruit-flavored beer.

The payback period is the length of time it takes the project to “break even” in terms of its cash flows. The table above shows us that the payback period lies somewhere during the fourth year.

To derive a more specific answer, we proceed as follows. At the beginning of Year 4, the cumulative net cash flow was -$10,000. We simply divide the absolute value of this amount by the total Year 4 cash flow of $50,000 to estimate when in Year 4 the project breaks even:

$$ \frac{10000}{50000}=0.2=20\% $$

So the fruit-beer project will break even 20% of the way through Year 4. In other words, the payback period for this investment is 3.2 years.