Framework
Capital budgeting techniques
The question it answers
When a CFO must choose between long-term investment projects, should NPV, IRR, payback or the profitability index decide, and where can each one mislead?
- Origin
- Dean (1951) applies the discounted-cash-flow logic of Fisher (1930) and Williams (1938); practice survey in Graham and Harvey (2001)
- Diagram type
- Comparison table
- Level of analysis
- Firm
- Topics
- Corporate finance
Diagram
Capital budgeting techniques
| Criterion | Accept if | Strength | Weakness |
|---|---|---|---|
| NPV | Above zero | Value in money terms | Sensitive to the discount rate |
| IRR | Above cost of capital | Intuitive percentage | Multiple IRRs; reinvestment assumption |
| Payback | At or below target | Liquidity focus | Ignores time value and later cash |
| Profitability index | Above 1 | Useful under capital rationing | Blind to project scale |
| Accounting rate of return | Above target | Uses accounting data | Ignores cash timing |
Sources
References
Listed A–Z by author surname, Harvard style. A source with a DOI links to https://doi.org/…; one without links to its page or says plainly that it has no DOI.
- Dean, J. (1951) Capital Budgeting: Top-Management Policy on Plant, Equipment, and Product Development. New York: Columbia University Press.No DOISource page
- Fisher, I. (1930) The Theory of Interest. New York: Macmillan.No DOISource page
- Graham, J.R. and Harvey, C.R. (2001) ‘The theory and practice of corporate finance: evidence from the field’, Journal of Financial Economics, 60(2–3), pp. 187–243.doi:10.1016/s0304-405x(01)00044-7Source page
- Williams, J.B. (1938) The Theory of Investment Value. Cambridge, MA: Harvard University Press.No DOISource page