Capital Budgeting – When we study about Financial Management, we often consider taking decisions regarding investing in which project out of the various available options. To make this decision easier & more meaningful, we may adopt a variety of techniques. These techniques are called – The Capital Budgeting Techniques.
Let us have a look on what is capital budgeting & what are the various techniques involved in it.
Capital Budgeting – What is?, Various Techniques or Methods
What is Capital Budgeting?
Capital budgeting refers to long-term planning for proposed capital outlays and their financing. Thus, it includes both raising of long-term funds as well as their utilization. It may, thus, be defined as the “firm’s formal process for acquisition and investment of capital.”
What are the various Capital Budgeting Techniques?
- Payback Period
- Net Present Value
- Profitability Index
- Internal Rate of Return
Let us now a brief look on each of these methods.
Payback Period Method:
- The Pay Back period is the amount of time required for the firm to recover its initial investment in a project, as calculated from cash
- Payback period = Total initial capital investment/ Annual expected after tax cash inflow
Decision Criteria:
- If the payback period is less than the maximum acceptable payback period, accept the project.
- If the payback period is greater than the maximum acceptable payback period, reject the project.
NET PRESENT VALUE:
- The Net Present Value (NPV) is found by subtracting a project’s initial investment (Initial Cash Outflow) from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital
Decision Criteria:
- If the NPV is greater than 0, accept the project.
- If the NPV is less than 0, reject the project.
For further details on Net Present Value, you can refer my article Net Present Value
PROFITABILITY INDEX:
- The profitability index (PI) is simply equal to the present value of cash inflows divided by the initial cash outflow.
- PI = Present Value of Cash Inflows/ Present Value of Cash Outflows
Decision Criteria
- If PI > 1 then accept the project
- If PI < 1 then reject the project
For further details on Profitability Index, you can refer my article profitability index
INTERNAL RATE OF RETURN:
- The Internal Rate of Return (IRR) refers to the rate which equates the present value of cash inflows and present value of cash outflows. In other words, it is the rate at which net present value of the investment is zero.
Decision Criteria
- If the IRR is greater than the cost of capital, accept the project.
- If the IRR is less than the cost of capital, reject the project.
For further details on Internal Rate of Return, you can refer my article
Apart from the techniques mentioned above, there are other techniques also like Surplus Life over Payback Period, Average Rate of Return, Cost Benefit Ratio, etc. which can be used for various specific situations.
