Techniques of Capital Budgeting in

Manufacturing Industry

1.
Capital budgeting will help determine if a manufacturer should replace a piece of equipment.
The manufacturing industry depends on having good equipment to use in the production process. As
equipment breaks down, companies need to decide whether or not to replace the older equipment
with newer models. When companies want to expand, they also need to make decisions regarding
the equipment they should purchase for that expansion. The most common techniques used for
capital budgeting are payback, internal rate of return and net present value.
Payback
2. Payback is the simplest method to use and is often employed as a first step in the process of
capital budgeting. Payback simply looks at how many years it will take for an investment to earn
back the money it will cost. Companies first need to determine the number of years they'd require for
a project to pay for itself. Then the manager looks at the expected cash flows of the project. She first
determines what the total cost of the investment will be. Then each year's cash flows are calculated
and subtracted from the total cost of the investment. Once the balance reaches zero, the number of
years to reach that point is determined. This is compared to the company's required number of
years. If the project will take longer than the required number of years, it will not be approved. If the
project will take less than the required number of years, it will be approved. 
While the payback method is simple to use, it does have some disadvantages. It does not consider
the time value of the money or change in value of the money at the time it is received due to
inflation. Payback also does not consider the cash flows that occur after the payback point has been
reached.
Net Present Value
3. Net present value is a technique that uses all of the cash flows into and out of a project over
the project's life. This technique also considers the change in value of the cash flows at various
points in time. All of the cash flows, in and out of the company, are estimated for the life of the
project. Present value refers to the value of each cash flow in today's dollars. The manager uses
present value tables or calculators and an estimated rate of return to determine the present value of
each of those cash flows. Once all of the present values have been determined, they are added or
subtracted to determine the total present value of the project. If the net present value is greater than
one, it is approved. If it is less than one, it is rejected.
Net present value does consider the time value of the cash flows and the lifetime cash flows of the
project. However, it is more complex and takes more time to determine.
Internal Rate of Return
4. The internal rate of return estimates a rate of return for the project and compares this rate to
the company's required rate of return. It determines what rate will make the net present value equal
to zero. This is often done through trial and error by using different interest rates to calculate net
present value of a project until the net present value equals zero. Once the internal rate of return is
determined, it is compared to the company's required rate of return. If the internal rate of return is
higher, the project is approved. If the internal rate of return is lower, the project is rejected.
Some managers like to compare the percentage rates rather than look at dollars. Internal rate of
return is an easy way to compare these rates. On the other hand, it can be cumbersome to
calculate.