Capital budgeting is the process by which an organization evaluates and selects long-term investment projects. An organization's capital budget represents its expected commitments to long-term investments, such as investments in capital equipment, purchase or lease of buildings, purchase or lease of vehicles, and so forth. In this chapter, we will explore the various techniques used to make capital budgeting decisions and apply the mathematics of compound interest introduced in the previous chapter.
One capital budgeting technique that is widely used by small businesses but seldom employed in large corporations is the payback method. This method has wide popularity due both to the simplicity of its decision rule and to its sensitivity to the scarcity of capital -- an important factor in many small businesses. It requires calculation of the number of years required to pay back the original investment. If a choice must be made between two mutually exclusive investment projects, one simply chooses the project with the shortest payback period. If a "go-no go" decision is to be made, one simply compares the project's payback with some predetermined standard. In this case, a simple decision rule such as "accept all projects with a payback of less than five years and reject all others" may be used.
Although payback is a simple rule to apply, it is a very poor method on which to rely for the allocation of a firm's scarce capi-