Capital budgeting involves the evaluation of potential projects that usually extend for several accounting periods. There are several tools available to assist in the financial ranking of the projects being considered.
Since the projects involve more than one accounting period, it is wise to use techniques that consider the time value of money. These techniques utilize present value calculations, rather than simply using the unadjusted future amounts. In other words, present value calculations discount the future amounts. A dollar received one year from today will have a lower present value than one dollar. The dollar received two years from today will have a present value that is less than a dollar received in one year, and so on.
Two common techniques which use present value calculations are (1) net present value, and (2) internal rate of return. The net present value technique discounts the future cash flow by a specified interest rate. (The interest rate will likely be the required minimum return that a company will accept for the project being considered.) If the present value of the future cash flows is greater than the cash outlay, the project is said to have a positive net present value. This positive excess is the amount earned over and above the return that was used to discount the future cash flows.
The second technique that recognizes the time value of money is the internal rate of return. The internal rate of return calculates the rate that will discount the future cash flows to exactly the amount of the cash outlay.
There are also some techniques that do not consider the time value of money. One is the payback method. This technique looks at a project's cash flows and calculates the years it will take to recoup the initial cash outlay. A shorter payback is viewed to be better than a longer payback. The drawback to this method is that it looks only at the early years of a project and stops when the cumulative amount reaches the amount of the investment. All of the cash received after that point is not considered.
The accounting rate of return is another technique that does not consider the time value of money. At best it gives you an average return based on the income statement amounts in relationship to the amount invested.
To recap, the net present value method and the internal rate of return use all of the cash flows from a project and will discount them with present value calculations. The payback method uses only some of the cash flows and does not discount them. The accounting rate of return does not use cash flows and does not discount the amounts.