There are three steps in the general approach to capital budgeting. First, the decision maker must make a list of possible long-term investments. Second, the decision maker shall study the advantages and disadvantages of each alternative capital investment, taking into consideration the variance of each project’s net cash inflows. Third, the decision maker must choose the best alternative (McGuigan, 2010). Incremental cash inflow is the list of the company’s cash outflows as well as a list of the company’s cash inflows. The cash outflow represents all payments for purchases of capital investments as well as operating expenses. The cash inflow includes the revenues from the project. The net cash flow is the difference between the cash inflows and the cash outflows (McGuigan, 2010).
Payback period indicates how long the business or entity will recover its investments or capital budgeting amount. In terms of the payback period decision rule, the project that has the shorter payback period is better than another project having a longer payback period (McGuigan, 2010).
The net present value method in capital budgeting shows the variance between two amounts. The first amount is the cash inflows. The second amount is the cash outflows. The net present value is the difference between the total cash inflows and the total cash outflows. The decision maker should invest in a project if the total present values exceed the total cash outflows (McGuigan, 2010).
In economic terms, the net present value represents the contribution of the investment to the firm’s value, and to shareholders’ wealth maximization. The present value is the value today of a future amount cash amount or series of cash payments computed using the appropriate discount interest rate (McGuigan, 2010).
The Internal rate of return is used to determine whether the decision maker should choose the one project over the other alternative projects. If the internal rate of return of a project is lower than the capital investment costs, the decision maker must drop the project. The internal rate of return is the interest rate used to arrive at a net present value of zero.