Capital budgeting decisions are the decisions that small-business owners make about the long-term allocation of resources. Effective managers make capital budgeting decisions while using data-driven analyses. Knowing some of the most common capital budgeting decision techniques can help you use these methods to make long-term choices that are best for your business.

Net Present Value

To most business owners, a dollar today is worth more than a dollar 10 years in the future. This idea, called the time value of money, is pivotal in the net present value method of capital budgeting. A cash flow's present value is the value that a cash flow would have today, in contrast with some time in the future. To evaluate an investment based upon net present value, the manager will calculate the net present value of an investment by subtracting the present value of the investment's cash inflows and cash outflows. If the result is positive, the investment may be acceptable. However, if the result is negative, then once the time value of money is considered, the company is better off by not investing in the project. In addition, many companies compare this value to a required rate of return. For example, if a company could earn 10 percent interest in an investment account, then any project that returns less than 10 percent would be less profitable than the investment account and should be rejected, even though the net present value is positive.

Total Cost Approach

When comparing multiple capital budgeting projects, small-business owners may want to consider the total cost approach. To use this method, small-business owners create a schedule of all of the costs and cash inflows for each decision alternative. Then, each cost or inflow is adjusted, on a time value of money basis, to a present value. Once all of the present value-adjusted costs are aggregated for each decision alternative, the alternative with the greatest net present value is the most profitable. As a drawback, because the total cost approach requires small-business owners to identify every cost involved in each decision alternative, the total cost method can be complicated and cumbersome.

Incremental Cost Approach

A simpler variation of the total cost approach is the incremental cost approach. This method uses the same procedure as the total cost approach. However, instead of examining all costs, only the costs that differ between the alternatives are used. These are known as relevant costs. Small-business owners may wish to consider this approach as it can be considerably less cumbersome; however, if more than two decision alternatives are being examined, the total cost method must be used.

Payback Method

The payback method helps a manager determine how long it will take for an investment to make enough cash to "pay back" the company for the cash outflow. To evaluate a budgeting decision under the payback method, the manager first computes the payback period. To calculate the payback period, the manager divides the investment's cost by the amount of cash that the investment is expected to generate on an annual basis. For example, if an investment required $10,000 and it was expected to produce $5,000 of cash inflow a year, the payback period would be two years. When choosing between capital budgeting alternatives, managers should choose the alternative with the shortest payback period. One major drawback of this method is that it fails to account for the time value of money. In this method, cash flows now are evaluated with the same value as cash flows in the future.