# Capital Budgeting – What is?, Various Techniques or Methods

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?__

__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?__

__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__:

__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:__

__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:__

__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:__

__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.