Ag Decision Maker

extension.iastate.edu/agdm
Capital Budgeting Basics File C5-240

Capital investments are long-term investments 3. Estimate and analyze the relevant cash flows of
in which the assets involved have useful lives of the investment proposal identified in Step 2.
multiple years. For example, constructing a new 4. Determine financial feasibility of each of the
production facility and investing in machinery investment proposals in Step 3 by using the
and equipment are capital investments. Capital capital budgeting methods outlined below.
budgeting is a method of estimating the financial
viability of a capital investment over the life of the 5. Choose the projects to implement from among
investment. the investment proposals outlined in Step 4.
6. Implement the projects chosen in Step 5.
Unlike some other types of investment analysis,
capital budgeting focuses on cash flows rather 7. Monitor the projects implemented in Step 6 as to
than profits. Capital budgeting involves identifying how they meet the capital budgeting projections
the cash in flows and cash out flows rather than and make adjustments where needed.
accounting revenues and expenses flowing from There are several capital budgeting analysis methods
the investment. For example, non-expense items that can be used to determine the economic
like debt principal payments are included in capital feasibility of a capital investment. They include the
budgeting because they are cash flow transactions. Payback Period, Discounted Payment Period, Net
Conversely, non-cash expenses like depreciation Present Value, Profitability Index, Internal Rate of
are not included in capital budgeting (except to the Return, and Modified Internal Rate of Return.
extent they impact tax calculations for “after tax”
cash flows) because they are not cash transactions. Payback Period
Instead, the cash flow expenditures associated with A simple method of capital budgeting is the Payback
the actual purchase and/or financing of a capital Period. It represents the amount of time required for
asset are included in the analysis. the cash flows generated by the investment to repay
the cost of the original investment. For example,
Over the long run, capital budgeting and assume that an investment of $600 will generate
conventional profit-and-loss analysis will lend to annual cash flows of $100 per year for 10 years. The
similar net values. However, capital budgeting number of years required to recoup the investment is
methods include adjustments for the time value of six years.
money (discussed in File C5-96, Understanding the
Time Value of Money, www.extension.iastate.edu/ The Payback Period analysis provides insight into
agdm/wholefarm/pdf/c5-96.pdf). Capital investments the liquidity of the investment (length of time until
create cash flows that are often spread over several the investment funds are recovered). However,
years into the future. To accurately assess the value the analysis does not include cash flow payments
of a capital investment, the timing of the future cash beyond the payback period. In the example above,
flows are taken into account and converted to the the investment generates cash flows for an additional
current time period (present value). four years beyond the six year payback period.
The value of these four cash flows is not included
Below are the steps involved in capital budgeting. in the analysis. Suppose the investment generates
1. Identify long-term goals of the individual or cash flow payments for 15 years rather than 10. The
business. return from the investment is much greater because
2. Identify potential investment proposals for there are five more years of cash flows. However,
meeting the long-term goals identified in Step 1. the analysis does not take this into account and the
Payback Period is still six years.
Reviewed June 2023
Page 2 Ag Decision Maker File C5-240, Capital Budgeting Basics

Table 1. Payback period analysis of future cash flow payments for three capital projects.
Project A Project B Project C
Year Cash Flow Cumulative Cash Flow Cumulative Cash Flow Cumulative
0 -$1,000 -$1,000 -$1,000
1 $250 $250 $350 $350 $500 $500
2 $250 $500 $350 $700 $500 $1,000
3 $250 $750 $350 $1,050 $500 $1,500
4 $250 $1,000 $350 $1,400
5 $250 $1,250 $350 $1,750
6 $250 $1,500
7 $250 $1,750
8 $250 $2,000
9 $250 $2,250
10 $250 $2,500

Payback period comparison

Project Payback Period Cash Return
A 4 yrs. $2,500
B 3 (2.86) yrs. $1,750
C 2 yrs. $1,500

Three capital projects are outlined in Table 1. Each Figure 1. Discounting a series of future cash flows.
requires an initial $1,000 investment. But each
project varies in the size and number of cash flows
generated. Project C has the shortest Payback Period
of two years. Project B has the next shortest Payback
(almost three years) and Project A has the longest
(four years). However, Project A generates the most
return ($2,500) of the three projects. Project C,
with the shortest Payback Period, generates the least
return ($1,500). Thus, the Payback Period method is
most useful for comparing projects with nearly equal To properly discount a series of cash flows, a
lives. discount rate must be established. The discount
rate for a company may represent its cost of capital
Discounted Payback Period or the potential rate of return from an alternative
The Payback Period analysis does not take into investment.
account the time value of money. To correct for this
deficiency, the Discounted Payback Period method The discounted cash flows for Project B in Table
was created. As shown in Figure 1, this method 1 are shown in Table 2. Assuming a 10% discount
discounts the future cash flows back to their present rate, the $350 cash flow in year one has a present
value so the investment and the stream of cash flows value of $318 (350/1.10) because it is only
can be compared at the same time period. Each of discounted over one year. Conversely, the $350
the cash flows is discounted over the number of cash flow in year five has a present value of only
years from the time of the cash flow payment to the $217 (350/1.10/1.10/1.10/1.10/1.10) because it is
time of the original investment. For example, the discounted over five years. The nominal value of the
first cash flow is discounted over one year and the stream of five years of cash flows is $1,750 but the
fifth cash flow is discounted over five years. present value of the cash flow stream is only $1,326.
Ag Decision Maker File C5-240, Capital Budgeting Basics Page 3

Table 2. Discounting a series of future cash flows cash flows like Project A. It takes an additional 1.37
(10% discount rate). years to repay Project A when the cash flows are
Present Value of discounted. It should be noted that although Project
Year Cash Flows Cash Flows A has the longest Discounted Payback Period, it also
0 has the largest discounted total return of the three
1 $350 $318 projects ($1,536).
2 $350 $289
3 $350 $263
4 $350 $239 Net Present Value
5 $350 $217 The Net Present Value (NPV) method involves
Total $1,750 $1,326 discounting a stream of future cash flows back to
present value. The cash flows can be either positive
In Table 3, a Discounted Payback Period analysis (cash received) or negative (cash paid). The present
is shown using the same three projects outlined in value of the initial investment is its full face value
Table 1, except the cash flows are now discounted. because the investment is made at the beginning
You can see that it takes longer to repay the of the time period. The ending cash flow includes
investment when the cash flows are discounted. For any monetary sale value or remaining value of the
example, it takes 3.54 years rather than 2.86 years capital asset at the end of the analysis period, if any.
(.68 of a year longer) to repay the investment in The cash inflows and outflows over the life of the
Project B. Discounting has an even larger impact for investment are then discounted back to their present
investments with a long stream of relatively small values.

Table 3. Discounting payback period analysis of three $1,000 investments.

Project A Project B Project C
Year Cash Flow Cumulative Cash Flow Cumulative Cash Flow Cumulative
0 -$1,000 -$1,000 -$1,000
1 $227 $227 $318 $318 $455 $455
2 $207 $434 $289 $607 $413 $868
3 $188 $622 $263 $870 $376 $1,244
4 $171 $792 $239 $1,109
5 $155 $948 $217 $1,326
6 $141 $1,089
7 $128 $1,217
8 $117 $1,334
9 $106 $1,440
10 $96 $1,536

Payback period comparison

Project Payback Period Cash Return
A 6 (5.37) $1,536
B 4 (3.54) $1,326
C 3 (2.35) $1,244

Time difference between payback period and discounted payback period

Years Project A Project B Project C
Payback Period 4.00 2.86 2.00
Discounted Payback Period 5.37 3.54 2.35
Difference 1.37 .68 .35
Page 4 Ag Decision Maker File C5-240, Capital Budgeting Basics

The Net Present Value is the amount by which the It may represent the rate of return needed to attract
present value of the cash inflows exceeds the present outside investment for the capital project. Or it may
value of the cash outflows. Conversely, if the present represent the rate of return the company can receive
value of the cash outflows exceeds the present from an alternative investment. The discount rate
value of the cash inflows, the Net Present Value is may also reflect the Threshold Rate of Return (TRR)
negative. From a different perspective, a positive required by the company before it will move forward
(negative) Net Present Value means that the rate of with a capital investment. The Threshold Rate of
return on the capital investment is greater (less) than Return may represent an acceptable rate of return
the discount rate used in the analysis. above the cost of capital to entice the company to
make the investment. It may reflect the risk level
Net Present Value = Present value of cash inflows - of the capital investment. Or it may reflect other
present value of cash outflows factors important to the company. Choosing the
Net Present Value Rule = Accept investments with proper discount rate is important for an accurate Net
a positive Net Present Value and reject investments Present Value analysis.
with a negative Net Present Value.
A simple example using two discount rates is shown
The discount rate is an integral part of the analysis. in Table 4. If the five percent discount rate is used,
The discount rate can represent several different the Net Present Value is positive and the project is
approaches for the company. For example, it may accepted. If the 10% rate is used, the Net Present
represent the cost of capital such as the cost of Value is negative and the project is rejected.
borrowing money to finance the capital expenditure
or the cost of using the company’s internal funds.

Table 4. Net present value analysis (5% and 10% discount rates).
Assume:
Capital expenditure = $10,000
Useful life of expenditure = 5 years
Annual return from expenditure = $2,000
Value of investment at the end of the analysis period = $1,000
Discount rate = 5% and 10%

Capital Investment Present Value of Cash Flows

Year and Ending Value Annual Return Net Cash Flows 5% Discount 10% Discount
0 -$10,000 $-10,000 $-10,000 -$10,000
1 $2,000 $2,000 $1,905 $1,818
2 $2,000 $2,000 $1,814 $1,653
3 $2,000 $2,000 $1,728 $1,503
4 $2,000 $2,000 $1,645 $1,366
5 $3,000 $2,000 $5,000 $3,918 $3,105
Total $1,010 -$555

Net Present Value

5% Discount Rate = $1,010
10% Discount Rate = -$555
Ag Decision Maker File C5-240, Capital Budgeting Basics Page 5

Profitability Index The Profitability Index is a variation of the Net

Another measure to determine the acceptability of Present Value approach to comparing projects.
a capital investment is the Profitability Index (PI). Although the Profitability Index does not stipulate
The Profitability Index is computed by dividing the amount of cash return from a capital investment,
the present value of cash inflows of the capital it does provide the cash return per dollar invested.
investment by the present value of cash outflows of The index can be thought of as the discounted cash
the capital investment. If the Profitability Index is inflow per dollar of discounted cash outflow. For
greater than one, the capital investment is accepted. example, the index at the five percent discount rate
If it is less than one, the capital investment is returns $1.10 of discounted cash inflow per dollar
rejected. of discounted cash outflow. The index at the 10%
discount rate returns only 94.5 cents of discounted
cash inflow per dollar of discounted cash outflow.
Profitability Index = Present Value of Cash Inflows Because it is an analysis of the ratio of cash inflow
Present Value of Cash Outflows
per unit of cash outflow, the Profitability Index is
Profitability Index Rule = Accept investments if the useful for comparing two or more projects which
Profitability Index is greater than one and reject
investments if the Profitability Index is less than one.
have very different magnitudes of cash flows.

A Profitability Index analysis is shown with two

Internal Rate of Return
Another method of analyzing capital investments
discount rates (5% and 10%) in Table 5. The
is the Internal Rate of Return (IRR). The Internal
Profitability Index is positive (greater than one)
Rate of Return is the rate of return from the
with the five percent discount rate. The Profitability
capital investment. In other words, the Internal
Index is negative (less than one) with 10% discount
Rate of Return is the discount rate that makes the
rate. If the Profitability Index is greater than one,
Net Present Value equal to zero. As with the Net
the investment is accepted. If it is less than one, it is
Present Value analysis, the Internal Rate of Return
rejected.
can be compared to a Threshold Rate of Return to
Table 5. Profitability index comparison analysis determine if the investment should move forward.
(5% and 10% discount rates).
Internal Rate of Return = The discount rate that
Present Value of Cash Flows makes the Net Present Value equal to zero; that is,
Year Cash Flows 5% Discount 10% Discount discounted cash inflows are just equal to discounted
0 $-10,000 -$10,000 -$10,000 cash outflows

1 $2,000 $1,905 $1,818 Internal Rate of Return Rule = Accept investments

if the Internal Rate of Return is greater than the
2 $2,000 $1,814 $1,653 Threshold Rate of Return and reject investments if
3 $2,000 $1,728 $1,503 the Internal Rate of Return is less than the Threshold
Rate of Return.
4 $2,000 $1,645 $1,366
5 $5,000 $3,918 $3,105
An Internal Rate of Return analysis for two
Total $1,010 -$555 investments is shown in Table 6. The Internal Rate
of Return of Project A is 7.9%. If the Internal Rate
$11,010
Profitability Index (5%) =
$10,000
= 1.101 of Return (e.g. 7.9%) is above the Threshold Rate of
Return (e.g. 7%), the capital investment is accepted.
$9,445
If the Internal Rate of Return (e.g. 7.9%) is below
Profitability Index (10%) = = .9445 the Threshold Rate of Return (e.g. 9%), the capital
$10,000
investment is rejected. However, if the company is
choosing between projects, Project B will be chosen
because it has a higher Internal Rate of Return.
Page 6 Ag Decision Maker File C5-240, Capital Budgeting Basics

Table 6. Internal Rate of Return analysis. However, to accurately discount a future cash flow,
Cash Flows it must be analyzed over the entire five year time
Year Project A Project B period. So, as shown in Figure 3, the cash flow
0 -$10,000 -$10,000 received in year three must be compounded for two
1 $2,500 $3,000
years to a future value for the fifth year and then
2 $2,500 $3,000
3 $2,500 $3,000
discounted over the entire five-year period back to
4 $2,500 $3,000 the present time. If the interest rate stays the same
5 $2,500 $3,000 over the compounding and discounting years, the
Total $12,500 $15,000 compounding from year three to year five is offset by
the discounting from year five to year three. So, only
IRR 7.9% 15.2%
the discounting from year three to the present time
The Internal Rate of Return analysis is commonly is relevant for the analysis (Figure 2).
used in business analysis. However, a precaution
For the Discounted Payback Period and the Net
should be noted. It involves the cash surpluses/
Present Value analysis, the discount rate (the rate
deficits during the analysis period. As long as the
at which debt can be repaid or the potential rate of
initial investment is a cash outflow and the trailing
return received from an alternative investment) is
cash flows are all inflows, the Internal Rate of Return
used for both the compounding and discounting
method is accurate. However, if the trailing cash
analysis. So only the discounting from the time of
flows fluctuate between positive and negative cash
the cash flow to the present time is relevant.
flows, the possibility exists that multiple Internal
Rates of Return may be computed. However, the Internal Rate of Return analysis
involves compounding the cash flows at the Internal
Modified Internal Rate of Return Rate of Return. If the Internal Rate of Return is high,
Another problem with the Internal Rate of Return the company may not be able to reinvest the cash
method is that it assumes that cash flows during flows at this level. Conversely, if the Internal Rate of
the analysis period will be reinvested at the Internal Return is low, the company may be able to reinvest
Rate of Return. If the Internal Rate of Return is at a higher rate of return. So, a Reinvestment Rate of
substantially different than the rate at which the cash Return (RRR) needs to be used in the compounding
flows can be reinvested, the results will be skewed. period (the rate at which debt can be repaid or
the rate of return received from an alternative
To understand this we must further investigate
investment). The Internal Rate of Return is then the
the process by which a series of cash flows are
rate used to discount the compounded value in year
discounted to their present value. As an example, the
five back to the present time.
third year cash flow in Figure 2 is shown discounted
to the current time period.

Figure 2. Understanding discounting of a series of Figure 3. Understanding discounting of a series of

cash flows. cash flows.
Ag Decision Maker File C5-240, Capital Budgeting Basics Page 7

Figure 4. Understanding Modified Internal Rate of Table 7. Modified Internal Rate of Return analysis of
Return analysis. future cash flows for two $10,000 investments.
Cash Flows
Year Project A Project B
0 -$10,000 -$10,000
1 $2,500 $3,000
2 $2,500 $3,000
3 $2,500 $3,000
4 $2,500 $3,000
5 $2,500 $3,000
Total $2,500 $5,000
Modified Internal Rate of Return = The Discount Rate
that makes the Net Present Value equal to zero when IRR 7.9% 15.2%
a Reinvestment Rate of Return is included in the MIRR (7% RRR) 7.5% 11.5%
analysis MIRR (9% RRR) 8.4% 12.4%
Modified Internal Rate of Return Rule = Accept
investments if the Modified Internal Rate of Return is Comparison of Methods
greater than the Threshold Rate of Return and reject For a comparison of the six capital budgeting
investments if the Modified Internal Rate of Return is methods, two capital investments projects are
less than the Threshold Rate of Return. presented in Table 8 for analysis. The first is a
$300,000 investment that returns $100,000 per year
The Modified Internal Rate of Return for two for five years. The other is a $2 million investment
$10,000 investments with annual cash flows of that returns $600,000 per year for five years.
$2,500 and $3,000 is shown in Table 7. The Internal
Rates of Return for the projects are 7.9% and 15.2%, Both projects have Payback Periods well within the
respectively. However, if we modify the analysis five-year time period. Project A has the shortest
where cash flows are reinvested at 7%, the Modified Payback Period of three years and Project B is only
Internal Rates of Return of the two projects drop to slightly longer. When the cash flows are discounted
7.5% and 11.5%, respectively. If we further modify (10%) to compute a Discounted Payback Period,
the analysis where cash flows are reinvested at 9%, the time period needed to repay the investment is
the first Modified Internal Rate of Return rises to longer. Project B now has a repayment period over
8.4% and the second only drops to 12.4%. If the four years in length and comes close to consuming
Reinvestment Rate of Return is lower than the the entire cash flows from the five-year time period.
Internal Rate of Return, the Modified Internal Rate
of Return will be lower than the Internal Rate of The Net Present Value of Project B is $275,000
Return. The opposite occurs if the Reinvestment compared to only $79,000 for Project A. If only
Rate of Return is higher than the Internal Rate of one investment project will be chosen and funds
Return. In this case the Modified Internal Rate of are unlimited, Project B is the preferred investment
Return will be higher than the Internal Rate of because it will increase the value of the company by
Return. $275,000.

However, Project A provides more return per dollar

of investment as shown with the Profitability Index
($1.26 for Project A versus $1.14 for Project B). If
funds are limited, Project A will be chosen.
Page 8 Ag Decision Maker File C5-240, Capital Budgeting Basics

Table 8. Comparison of Capital Budgeting Methods (10% discount Conclusion

rate and reinvestment rate of return) Each of the capital budgeting
Cash Flows methods outlined has advantages and
Year Project A Project B disadvantages. The Payback Period is
0 -$300,000 -$2,000,000 simple and shows the liquidity of the
1 $100,000 $600,000 investment. But it doesn’t account for
2 $100,000 $600,000 the time value of money or the value of
3 $100,000 $600,000 cash flows received after the payback
4 $100,000 $600,000
period. The Discounted Payback Period
5 $100,000 $600,000
Total $200,000 $1,000,000
incorporates the time value of money
but still doesn’t account for cash flows
Payback Period 3.00 yrs. 3.33 yrs. received after the payback period. The
Discounted Payback Period 3.75 yrs. 4.26 yrs. Net Present Value analysis provides a
(10% discount rate) dollar denominated present value return
Net Present Value $79,079 $274,472 from the investment. However, it has
(10% discount rate)
little value for comparing investments
Profitability Index 1.26 1.14
(10% discount rate)
of different size. The Profitability Index
Internal Rate of Return 19.9% 15.2% is a variation on the Net Present Value
Modified Internal Rate of Return 15.3% 12.9% analysis that shows the cash return per
(10% Reinvestment Rate of Return) dollar invested, which is valuable for
comparing projects. However, many
Both projects have a high Internal Rate of Return (Project A has
analysts prefer to see a percentage return
the highest). If only one capital project is accepted, it’s Project
on an investment. For this the Internal
A. Alternatively, the company may accept projects based on a
Rate of Return can be computed. But the
Threshold Rate of Return. This may involve accepting both or
company may not be able to reinvest the
neither of the projects depending on the size of the Threshold
internal cash flows at the Internal Rate of
Rate of Return.
Return. Therefore, the Modified Internal
When the Modified Internal Rates of Return are computed, Rate of Return analysis may be used.
both rates of return are lower than their corresponding Internal
Which capital budgeting method
Rates of Return. However, the rates are above the Reinvestment
should you use? Each one has unique
Rate of Return of 10%. As with the Internal Rate of Return, the
advantages and disadvantages, and
Project with the higher Modified Internal Rate of Return will be
companies often use all of them. Each
selected if only one project is accepted. Or the modified rates
one provides a different perspective on
may be compared to the company’s Threshold Rate of Return to
the capital investment decision.
determine which projects will be accepted.

This institution is an equal opportunity provider. Don Hofstrand, retired extension

For the full non-discrimination statement or agricultural business specialist,
accommodation inquiries, go to [email protected]
www.extension.iastate.edu/diversity/ext. extension.iastate.edu/agdm