Download This PaperA Capital Amortization Schedule (CAS) Method for Capital Budgeting and Cost-Benefit Analysis (CBA): A Better Substitute for the DCF Method
31 Pages Posted: 14 May 2020
Date Written: September 7, 2019
Abstract
The most popular DCF method for CBA and capital budgeting has been considered as “ambiguous or anomalous” as early as 1956 (Lorie and Savage). Recently Merlo (2017) argued that the DCF methodology cannot be a correct approach in some cases. Most published works attributed the multiple IRR as one of the limitations of IRR but not as a problem with the DCF method. Reinvestment and multiple IRR are, inter alia, the symptoms of the problems with the DCF method and the underlying causes are not hitherto completely evaluated. As these symptoms often reflect on the IRR, the IRR is considered as inferior to NPV. There is no research evidence available to support that assertion.
The important contribution of this paper is the identification and rectification of those underlying causes. The problems are with the nature of NCF (NNCF) and the failure of the DCF method to handle such NCFs. This analysis is conducted using a capital amortization schedule (CAS) based new method. The findings of this analysis are expected to open new vistas in CBA and capital budgeting. The important findings are:
A) the CAS method introduced is found to be a perfect substitute for the DCF method. The CAS method is transparent and has many advantages discussed here,
B) the CAS method, unlike the DCF method, clearly identifies and quantifies the reinvestment. Previously published works did not mention any such evidence and therefore obviously this is one of the valuable contributions of this study,
C) the results demonstrate that reinvestment is common with the NNCF investments but not with the normal NCF investments. This paper adds this important finding to the literature,
D) the CAS method reveals that reinvestment leads to multiple IRR and spurious NPV. Hitherto, the spurious nature of NPV caused by the reinvestment is neither studied nor reported and therefore the NPV rule has been supported,
E) the modified CAS (MCAS) method eliminates the reinvestment and thereby resolves the problem of multiple IRR and leads to a unique and real IRR and eliminates the spurious NPV too,
F) the CAS method allows estimating the IRR as a return on the total capital investment and on the declining balance of capital.
In conclusion, the CAS method and the findings of the present analysis add great value to the literature on and practice of CBA and capital budgeting.
Keywords: Capital Amortization Schedule (CAS) Method Is a Better Substitute for the DCF Method; CAS Method Illustrates Reinvestment Assumption Is Not Valid in All Cases
JEL Classification: C60; C63; D61; E22, E40; G3, G24; G31; H43; O2; O12; O16; O2
Suggested Citation: Suggested Citation