Capital Budgeting
Capital Budgeting refers to the long term financial decision regarding the acquisition and disposal of non-current assets. It is the decision regarding the selection of less risky and most profitable investment alternatives from the available one. It applies modern Investment evaluation techniques, also termed as capital budgeting techniques, like net present value, internal rate of return, profitability index, and discounted pay back period to evaluate the profitability of the investment.
Capital Budgeting Techniques
Here you will study about the popular five techniques of capital budgeting.
1. Net Present Value (NPV)
Net Present Value is the discounted method of evaluating investment alternatives so as to select the most profitable one. It is calculated by deducting present value of cash outflows from present value of cash inflows. Net Present Value may be both positive or negative. Higher the NPV most profitable will be the project and vice versa.
2. Internal Rate of Return (IRR)
IRR is one of the discounted method of evaluating investment alternatives. It is the rate at which the net present value of an project becomes zero. In other word, IRR is the rate at which the present value of cash inflows and present value of cash outflows become equal.
3. Profitability Index (PI)
A method of evaluating investment alternatives. PI is the ratio between present value of cash inflows and present value of cash outflows. It shows the number of times that the present value of cash inflows is more that the present value of cash outflows. It is calculated by dividing present value of cash inflows with present value of cash outflows. The project having the PI below 1 is unprofitable so it should be rejected. Projects having PI more than 1 are considered as profitable projects.
4. Discounted Payback Period (DPBP)
Discounted PBP is the modified version of payback period which consider the time value of money while calculating investment recover period i.e. pay back period. According to this method, at first the cash flows are discounted with discount rate and then the same procedure is followed as traditional PBP.
5. Pay Back Period (PBP)
Pay Back Period is one of the traditional method of evaluating investment opportunities. Pay Back Period refers to the number of years on which your investment will be recovered or returned back. Investment alternatives having lower pay back period is given more priority. It is simple to use but doesn’t consider the time value of money and risk & return.
The pay back period for the projects having even cash inflows is calculated by dividing initial outlay with annual cash inflow. For projects having uneven cash inflows, the cumulative cash flow table is prepared and then following formula is used:
PBP = Minimum Years + [(Amount to be Recorded)/Next year Cash Flow ]