CAPITAL BUDGETING DECISION TECHNIQUES

Adjusted Present Value (APV) is an evaluation technique which refers to the net present
value of an investment modified for tax and interest benefits of debt leveraging with equity as the
sole source of finance (Bierman & Smidt, 2012). The method examines the profitability of an
investment with applicable tax deductions due to debt financing. The calculation of Adjusted
Present Value requires one to first determine the net present value then incorporate the
adjustments in order to use the effects of the chosen mode of financing. Although the adjusted
present value is an alternative to the discounted cash flow method, it does not use the calculation
of the weighted average cost of capital.
The evaluation technique adopts a discount rate for tax shields that is different from that
which is determined from the cost of equity capital (Bierman & Smidt, 2012). This method
requires the approximation of the effects of debt financing on the probability of bankruptcy of
the firm. The major difference between the net present value and the adjusted present value is
that the latter is a modified version of the former due to debt financing.
Net Present Value (NPV) is the variance between the present cash inflows and present
cash outflows while taking the time value of money into consideration. It is an important factor
in investment decision making since it provides details on the possibility of achieving a target
yield from an investment (Fabozzi & Drake, 2009). The NPV of an investment can either be
positive, negative or zero. A positive NPV implies that the investor is charged a lesser amount
that the assets worthwhile the vice versa holds for a negative net present value. A zero NPV
indicates that the amount charged for an asset equals its worth.
There are additional business valuations techniques used in capital budgeting decisions which
include;

CAPITAL BUDGETING DECISION TECHNIQUES
Internal Rate of Return (IRR);
The internal rate of return is a valuation technique which determines the yield on an
investment by discounting of the present value of cash inflows against total cash outflows (Ross
et al, 2002). The IRR compares capital investments against other forms of investments. The
timing of cash flows for all investment options under consideration must be the same for one to
achieve reliable results when using IRR. For instance, an investor cannot compare the viability of
two investments with different time periods. The Internal Rate of Return is a percentage which is
arrived at by dividing expected yield by expected expenditure. The viability of an investment is
assessed by comparing the IRR and the hurdle rate which refers to the minimum percentage of
return that is acceptable (Ross et al, 2002). Although the IRR is easy to understand and is widely
used, the Net Present Value (NPV) is more accurate.
Payback Period;
Payback period is a technique which determines the length of time it takes to recover the
amount invested in a project. For example, if it takes a project 3 years to make the amount
invested then the payback period is 3. This technique does not take the time value of money into
consideration and is only favorable to investments that make returns in a short duration (Fabozzi
& Drake, 2009). Investments with short payback periods are preferable to investors who have
debt obligations that require being met in a short period of time.Discounted Cash Flow;
The Discounted Cash Flow (DCF) is a valuation technique which works by discounting
an investment’s future returns to present value. This method takes into consideration the time
value of money which implies that a dollar in hand in the present is worth more than the same
dollar in future. In the use of discounted cash flow, it requires one to first determine the discount
rate which can be a cost of equity or cost of capital depending on which of the two is under

CAPITAL BUDGETING DECISION TECHNIQUES
valuation (Bierman & Smidt, 2012). The discount rate applied by this technique determines the
expected rate of return on investment. It also establishes the long-term value of the investment
which is the amount at which the project can be disposed.

References

CAPITAL BUDGETING DECISION TECHNIQUES
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of
investment projects. Routledge.
Fabozzi, F. J., & Drake, P. P. (2009). Capital Budgeting Techniques. Handbook of
Finance.
Ross, S. A., Westerfield, R., Jaffe, J. F., & Roberts, G. S. (2002). Corporate finance (Vol.
7). New York: McGraw-Hill/Irwin.