Some capital expenditures are selected out of necessity, such as a government requirement to change the system for discharging environmentally harmful vapors or to comply with an OSHA requirement. After budgeting for the required capital expenditures, companies might use the following techniques for evaluating other capital expenditures.
Payback. This calculates the number of years it will take to recoup the cash spent on a project. A criticism of payback is that the time value of money is not considered and the cash flows over the entire life of the project are not considered.
Accounting Rate of Return or Return on Investment. This approach looks at the increase in accounting profit compared to the increased investment. This approach also ignores the time value of money.
Internal rate of return. This method does consider the time value of money and looks at the cash flows over the entire life of the project. The technique computes the rate that will discount the future cash flows to be equal to the cash outlay for the project.
Net present value. This method discounts the project's future cash flows by a predetermined rate, such as the targeted or needed rate. If the cash flows discounted by the targeted rate exceed the cash investment, the project is accepted. That is, the project provides the targeted return or more.