In this chapter, both traditional capital budgeting techniques and practical capital budgeting techniques are reviewed. At the same time, the limitations of traditional capital budgeting techniques are discussed and the usage of practical capital budgeting techniques to deal with these limitations. Traditional capital budgeting techniques include NPV, IRR and PB method. And the practical capital budgeting techniques involve real options method and simulation method.

2.1 Traditional capital budgeting techniques

Traditional capital budgeting techniques consist of discounted cash flow which involve NPV and IRR whereas non-discounted cash flow involve payback method.

2.1.1 Net Present Value (NPV).

Net present value is the difference between the amount invested and the present value of future cash flows (Alan, 2004). Charles et al (2009) reviewed that the NPV method calculates the expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows back to the present point in time using the required appropriate rate of return. Colin (2006) added that NPV is the most straightforward way to determine whether a project yields a return in excess of the alternative equal risk investment in trade securities.

NPV is the present value of the net cash inflows less the project’s initial investment outlay, if the rate of return from the project is greater than the return from an equivalent risk investment in securities traded in the financial market, the NPV will be positive, vice versa, if the rate of return is lower, the NPV will be negative (Colin, 2006). A positive NPV shows that an investment should be accepted, while a negative NPV shows that the investment should be rejected (Colin, 2006).

Kashyap (2006) added that the key inputs of the calculation of NPV are the interest rate or discount rate which used to compute the present values of future cash flows. When the discount rate higher than the shareholders’ required rate of return, and the project has a positive NPV at this rate, then shareholders will expect an additional profit that has a present value equal to the NPV (Kashyap, 2006). Formula for computing NPV is:

Source: Kashyap (2006).

Ct is the cash flow at time t, r is the discount rate and Co is the cash outflow at time 0 (Kashyap, 2006). In other words, this technique compares the value of a pound today to the value in the future by taking inflation and returns in consideration (Kashyap, 2006).

2.1.2. Internal Rate of Return (IRR)

IRR is another of capital budgeting technique which same as NPV technique in using the time value of money but results in answer expressed in percentage form (Pauline, 2006). IRR represents a discount rate which leads to a net present value of zero where the present value of the cash inflows equals to the cash outflows (Pauline, 2006). Charles et al (2009) added that IRR