Management use various Capital budgeting techniques to make effective use of these resource to maximize firm’s value (Bennouna, Geoffrey & Marchant 2010). The key objective of an organization is to determine the investment required for expansion of the project, modernize the existing equipment to reduce the costs or to anticipate demand (Bennouna, Geoffrey & Marchant 2010). In order to make further investment, managers determine the payback period and accounting rate of returns of the long term investments (Harrison & John 2010). Though there are several Capital Budgeting Techniques, However this document shall emphasizes on significance and limitation of Traditional Budgeting Techniques (Bennouna, Geoffrey & Marchant 2010). It further comments on the statement that ‘the traditional capital budgeting techniques hold its project passively, it further states that traditional capital budgeting technique does not acknowledge the value management.’
Traditional capital Budgeting
Traditional Capital Budgeting aims to measure the future cash in flows and out flows of the investment, it mainly uses the discounted rate option (Harrison & John 2010). Therefore, it is essential for the management of an organization to consider four main components to value investment opportunities, that is, accounting rate of return, payback period, present value of the project and its real option (Trivedi 2002).
Following are the advantages and disadvantages of Traditional Capital Budgeting: 1- Net Present Value Advantages Disadvantages It considers all the cash flows of the project It considers time value of money and reveals the potential of profitability of any investment. It incorporates the future risks of cash flow in the estimation of cost of capital, that is, discounted rate used to calculate NPV. It calculates discount rate or the cost of capital after calculating Net Present value. The results are in the currency, not percentage. The cost of capital is not constant; it affects the value of investment. It does not calculate the future cash flows of the investment proposal. This may affect the NPV calculation that may cause errors in the results. 2- Internal Rate of Return Advantages Disadvantages IRR considers all the cash flow that are generated through investments. It allows determining the true profitability potential of the investment. It addresses the time value of money. Similarly like NPV, the risks are incorporated during estimation of discount rate. IRR is not calculates cumulative values of two project at a time. It only values one project at a time. It provides multiple results, therefore the selection criteria is difficult. The results are contradicting as compared to the results of NPV. Cash flow forecasting and future value is difficult to calculate. It is essential for Capital Budgeting Techniques to collectively address the investment decision. Although Traditional Capital Budgeting techniques are considered to highly acceptable investment rule, because it consider time value of money, measure true profitability potential, value additively and aims to maximize shareholder’s values (Jensen & Meckling 1976) (Trigeorgis 2001). However, It has bee argued that the traditional capital budgeting or investment appraisal (that is Net Present Value, Internal Rate of Return) have not developed with the modern economy which significantly uses information technology (Harrison & John 2010). Traditional capital models estimates the incoming and outgoing of the cash flows of an entity through discounted cash flow (Hirschey 2008). The appraisal decisions based on the traditional