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private firm, one can combine the two definitions above and restate the definition of capital
budgeting as the decision-making process that is used to purchase assets that provide longterm
benefits to the organization.
2. Capital Budgeting Criteria
Competition is intense in the private-sector marketplace. Once a firm comes up with
a profitable investment project, competitors often rush in—which results in reduced prices
and profits. Due to this, private-sector firms must have a strategy to consistently generate
ideas for new capital projects. Without a consistent flow of new capital projects (or projects
that improve existing products), the firm will not be able to grow, or even survive, in the
private-sector marketplace. Like most public sector organizations, many private firms have
Research and Development (R&D) operations or departments that are tasked with coming
up with proposals for new capital projects and designing improvements to existing products
(Keown et al., 291-292). How are the capital project proposals generated by R&D evaluated
to determine profitability for the private firm?
Few methods are available to execute capital budgeting. These include the simple
payback period method (PB), the net present value method (NPV), the profitability index (PI)
method, and the internal rate of return method (IRR). Over the past fifty years, the focus on
a particular method has shifted almost every decade. The internal rate of return and the net
present value techniques slowly gained in popularity until today, where they are now used
by virtually all major corporations in decision-making (Keown et al., 2005).
In addition to the existing methods, computer modeling recently became available to
financial managers. This technique bridges the gap between theory and practical
application.
Choosing the appropriate methodology to execute capital budgeting is very
important. This review will discuss a few aspects of capital budgeting: net present value, the
internal rate of return, the payback method, computer modeling, and risk considerations.
Furthermore, it will introduce how the Fortune 1000 companies execute capital budgeting.
a. Net Present Value
The discounting methods of cash flow are based on discounting cash inflows and
outflows to their present values. Therefore, this technique considers the time value of
money. Clark, Hindelang, and Pritchard (1989) define the net present value computation as
follows:
NPV
n
= ∑
t=
0
CI t
( 1+
k)
t
− CO
0
CO = present value of the after-tax cost of the project
CI = the after-tax cash inflow to be received in period t
k = appropriate discount rate or hurdle rate
t = time period
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