A Review of Capital Budgeting Techniques

Abstract

Perhaps the single most important decision faced by management is the selection of investment projects that maximize the present value of shareholders’ wealth. This paper is a review of the literature on capital budgeting procedures. Analytic techniques such as Net present value (NPV), Internal rate of return (IRR), Payback, Discounted Payback, Time-adjusted discounting, Accounting Rate of Return, Profitability Index and Modified IRR are reviewed here. Additional supplementary techniques, when some complexities relating to risk and uncertainty are involved, are also discussed. Results of field surveys are reported. In sum, the results suggest increased prominence of the NPV as an evaluation technique consistent with its much emphasized academic merit. In particular, the Graham and Harvey (2001) survey reveals that the likelihood of using specific evaluation techniques is linked to three factors namely firm size, firm leverage and CEO characteristics. The study recommends the use of real options techniques as they facilitate the linkage of financial objectives with corporate strategy in the ever-increasingly complex business environment.