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Capital Budgeting--Theory and Practice
Dickerson, Peter J.
6/1  (Fall 1963): 53-60

Businessmen have long been aware that there exists a problem of allocating scarce resources among competing investment projects. An organization will increase its profit by accepting any investment project that yields revenues in excess of the costs of the resources needed for that project. The most obvious of the calculations combining a measurement of profit as a percentage of capital outlays with an allowance for the time factor is the internal rate of return. This is simply the discount rate which equates the expected net future cash inflows with the original capital outlay, and may be thought of as the rate of compound interest at which it would be possible to borrow and just break even. It follows, therefore, that the project offering the highest rate of return is tile most attractive project available. The present value of future income is the result of two elements, a projection of future income and the use of a rate to discount it to a present worth. The cost of equity capital is measured by determining the rate of discount needed to equate expected future cash flows to the stockholder with the market price of the stock. A more sophisticated method of assessing the merits of projects is the payout period. This has the theoretical advantage that it does rank projects by the income they produce, but it suffers from the fact that it takes no account of the income stream subsequent to the "recovery" of capital outlay nor does it differentiate between projects with different income patterns.

 

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